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Assuming Investment Success

The mistake of relying on market beahviour

by John Robertson (Reproduced from Edition 46 of ATC Digest)

Investors need to be clear about the behaviour they are relying on for investment success. Every product embodies a set of assumptions.

All investment products embody assumptions about likely behaviour patterns. If you buy a government bond, you assume that the government will return the principal upon maturity, as well as paying the agreed interest prior to the bond maturing. In an advanced economy, the chance of a government failing to fulfil these commitments is thought to be so low as to be riskless. Nonetheless, the product embodies certain assumptions about what will happen after a purchase.

Investors also assume that company share prices rise to reflect improved corporate financial performance. Events might intervene to make the connection between financial outcomes and share prices more or less immediate, but the broad connection underpins equity market activity. There is a long history and much analytical evidence to support the assumption.

These are two of the most straightforward examples of assumptions underlying investment decisions. A more complicated example might be the assumption underpinning the pricing of options. The conventional Black Scholes pricing model assumes that returns from the underlying equity prices conform to a log normal distribution. Returns, which do not conform to this pattern, potentially invalidate conclusions about what a call or put option is worth.

Within commodity markets, forward prices are generally assumed to reflect the warehousing and financing costs of holding physical commodities. Under normal market conditions, forward prices would be higher than spot prices for the same commodity.

The difference is referred to as the contango. However, if there is an unexpected shortage of commodities for immediate use, the spot price may be bid up to a point that it exceeds the forward price. In this case we say there is a backwardation. Buying material on the spot market and selling it for future delivery would no longer be commercially sensible. Products based on a continuation of a market contango will be invalidated.

The failure of investment products is frequently caused by the failure of these, or other assumptions, about likely market behaviour to eventuate.

Reappraising Risk in 2007
Reappraisal of risk was one of the investment themes of 2007, after investment risk had appeared to diminish greatly over the prior decade.

An unprecedented period of economic expansion, combined with strong profit growth, lower inflation and reduced volatility in returns, inured investors to some of the risks which earlier generations had to face.

Policy became more predictable and supportive of investment returns, too. Central bankers became progressively less anxious about inflation and more prepared to support economic activity and, indeed, investment market returns.

The so-called ‘Greenspan put’, in becoming a part of investment market terminology, affected investment expectations.

There should be no excuse for underestimating investment risks. Regulatory authorities routinely require that the risks of investments be identified and explained in some detail. Lawyers drafting exposure documents will typically ensure that few are left unmentioned.

When Wishful Thinking Dominates
But sometimes the investment promoters themselves might not have a firm grip on the risks which they are incurring.

Their non-disclosure is not dishonesty, but the product of a blinkered view of the world in which wishful thinking dominates sensible analysis.

The so-called sub prime crisis is a case in point. Banks have suffered the consequences over three decades of overly zealous lending to, firstly, Third World countries, then, greenmailing entrepreneurs and, following that, technology promoters. It was thought that nothing could be more secure than domestic real estate. “As safe as houses” is an adage based on a long history of rising real estate values.

Sub prime lending might make sense if you can count on real estate values always rising, or at least rising enough in the short-term to provide a cushion against any subsequent fall.

In this case, investors, including organisations as diverse as large US financial institutions and Australian local governments, were relying on a specific set of outcomes for their investment success. What they required was a continuing uptrend in housing prices, to underpin the value of loans and personal income growth, that was sufficient to outstrip rising debt servicing obligations.

This had been a balancing act households had seemingly perfected over the prior 15 years or more.

Despite an endless number of commentaries about the extent to which household finances were being stressed by rising debt burdens, the evident risks did not modify the types of product which were being developed. Indeed, the products ignored these risks in preference for an assumption that a favourable set of behaviours would continue indefinitely.

A new generation of investors, looking at a limited economic history, came to accept erroneously that the underlying assumptions of the sub prime products were an intrinsic feature of the economic system.

The recent failure of the Centro property group is another example of assumed behaviours not being realised. The chart below shows the spread between the three month US dollar LIBOR interest rate and the three month US government Treasury bill yield. Movements in the spread imply changes in the comfort level of banks about their lending environment.

There was a spectacular breakout in the spread dating from July 2007 when the effect of the sub prime crisis hit financial markets and banks became as uncomfortable as they had been for a long time. Centro had assumed a continuation of earlier behaviours, including a period of unprecedentedly comfortable credit market conditions.

The period since 2002, as illustrated in the chart, stands in marked contrast to the environments around 1987 and, to a lesser extent, around 2000; at least until six months ago. Centro behaved like a tennis player, striving to place each shot as close to the line as possible without going over. The tennis player can reasonably assume that the line will not move. Centro erroneously made a similar assumption and failed to allow a sufficient buffer to cover the possibility that the spreads might widen beyond where they had traded over the relatively short time since 2002 when Centro was putting its plans into action.

The GoldLink Income Plus Fund is another local example of investors assuming that a favourable set of behaviours would continue indefinitely. In this case, the unrealistic assumptions were about pricing in the gold market.

As the name of their product implies, the promoters of the GoldLink fund believed that they no longer needed higher gold prices to produce an attractive return, because they had found a way to generate income from the gold market. GoldLink employed complex strategies, otherwise unavailable to an individual investor, which involved borrowing physical gold from central banks, at relatively low rates of interest, and lending it to the market at much higher rates of interest.

This could be construed as relatively low risk in so far as the strategy did not rely on the gold price moving in a specific direction. However, taking a view about price might have been a less risky course. The strategy relied on central banks continuing to lend their gold holdings. Once the banks were persuaded that their lending was depressing the market, the behaviour underpinning the investment strategy was no longer valid and the company had to acknowledge that “the investment strategy requires reengineering to adapt to a different gold market environment”.

Another commodity market-related example is the so-called hedging activity of mining houses. By definition, hedging is eliminating risk. Companies, such as Pasminco, have failed catastrophically as a consequence of hedging, or so they claimed. In many cases, what was called hedging was nothing more than a blatant punt on the direction of an interest rate, exchange rate or commodity price. In other cases, hedging policies were assuming that forward prices would remain higher than spot prices. Once the cycle turned and this relationship failed to hold, the potential risks were realised.

A company anticipating delivery against forward contracts would be assuming that its production targets would be met. If production fell short, the company would have to buy back the forward positions. A backwardation could mean large losses on these transactions.

Questions for Investors
Investors need to ask what behaviour they are relying on for investment success. Is it something as simple as the payment of interest by a sovereign government, or is it a short-term policy, such as central bank gold lending, which can easily be reversed?

Once the assumed behaviour has been identified, an investor needs to judge how long that behaviour has been a feature of the market. The shorter the time during which the behaviour has been displayed, the more important it becomes for an investor to discover whether the behaviour is tied to a specific set of economic circumstances or policies, and whether those are susceptible to change.

GoldLink turned out to be anything but a relatively low risk commodity play. Centro became a play on spreads in global interest rates, remaining at historically low levels, rather than a property safe haven with an attractive yield.

In short, investors need to be analysing how likely it will be that the assumed behaviour patterns on which they are counting for investment success are actually realised and beyond that, how much of their portfolios is made up of risks peculiar to the investment products they have bought.

John Robertson is a member of the E.I.M. Capital Managers investment committee. He provides economic and investment analysis to the financial services industry through thebigpicture Economics. His economic and investment commentaries appear in the weekly AllThingsConsidered email (see www.atcbiz.com.au) for financial planners and the monthly ATC Digest, available free of charge to FINSIA financial advising special interest group members and by subscription to others.