Lehman Brothers' collapse defined the 2008
financial crisis but, beyond the immediate market crashes, the ramifications
really hit in 2011.
The year climaxed with the loss in August of America's triple-A status by one
of the major credit-rating agencies. The long, ugly denoument continues: as we
went to press, investors were turning their backs on German bunds - and it's
anyone's guess as to the status of the eurozone by the time our next edition
comes out in February 2012.
Investors have suffered far too many 'one in a million' disasters of late,
which is why there is such a strong desire for protection. But 2011 was the year
we learned there is no such thing as a risk-free asset.
Other efforts to mitigate risk have also been thwarted: take, for example,
the manner in which the credit-default swaps market for sovereign debt has been
completely sidestepped by European authorities. Or consider how the Japan
earthquake/tsunami and Thai floods have made a mockery of contingency planning.
A lot of so-called risk management is probably doomed to fail in a world of
such interconnectivity. The only true choice is to allocate out of risk, because
buying protection only passes that exposure to someone else, without changing
the net level of exposure. The notional derivatives market is some 16 times
global GDP. Nobody knows who's holding the hot potato, and whether they are 'too
big to fail'. This raises doubts as to whether shifting risk onto someone else
really protects you. For Asia and emerging markets, the idea of financial-market
decoupling seems more remote than ever.
If geographic diversification is no longer an aid, nor are other stock
answers from the textbooks of modern portfolio management. There is good reason
to assume that markets are not perfect and that prices do not reflect widely
known information - not when financial institutions keep their gains and
socialize their losses.
Nor can assets be valued against a risk-free rate - not when US Treasuries
are no longer triple-A, not when European sovereign bonds deliver enormous
losses, and not when interest rates in the US, Japan and Britain remain near
zero for such prolonged periods of time.
The correlation of all risk-asset returns (if not the risks themselves) first
experienced in 2008 has continued, prompting investors to flee traditional,
public securities markets in favour of things like real estate. This is a
terrible indictment of financial theory as well as of markets.
However, there is one aspect of traditional investment theory that has been
forgotten and deserves to be resuscitated. For many reasons, over time,
real-money investors have become too far caught up in chasing short-term market
movements. Today, in the face of so many unknowns and frightening outcomes, such
a tactical approach may make sense. But it comes at the expense of institutions'
comparative advantage in time. Few institutions are 'smart money', but they can
compensate through patience, and ride out storms. This is the true edge of
real-money investors. Is it possible for them to rediscover it?
The surrender of this comparative advantage has mainly occurred in the West.
Meanwhile, Asia's youthful institutions have actually been professionalizing.
This is good news and it must continue; bolder reforms are required in
organization, recruitment and remuneration.
In too many cases in Asia, even among supposedly sophisticated organizations,
investment professionals' decisions are under constant scrutiny by senior
managers and boards of trustees. There is no culture of empowering professionals
to take investment decisions. Senseless rotation systems continue to put
inexperienced non-specialists into investment roles, and then hustle them
elsewhere as soon as they start to figure things out.
Of course, accountability is vital, but it must be done within a framework
that encourages experienced professionals to get on with their job over a
reasonable period of time. The challenge for this region's institutions is
governance, not today's market plunge: addressing this is how they can exploit
their comparative advantage amidst global turmoil.
