Our quest for a far less risky future

The Financial Times has spent the last three weeks pondering the Future of Investing. We did not see the future. And even the present is surprising.

The reckoning that many predicted during the worst of the crisis has, at least, been postponed. Quant funds, which had their disaster as early as August 2007, are still in business, and trying out new strategies. With less money in them, they may even be less overcrowded, and more profitable, than they were before.

The widely predicted clean-out of hedge funds is also yet to happen. The March rebound came just in time to thwart it.

And the long-term nature of pensions ensures that their reckoning is delayed. Pension funds were in crisis two years ago. Since then, with lower yields and a disastrous fall in returns, that crisis has deepened, but it is still not imminent.

One change, however, is already clear. A certain humility has replaced the hubris of the years before the crisis.

And the future plainly holds many changes. The evolution of the industry depends on the answers to two questions: about risk and trust.

How can we manage risk?

The prevailing model of risk management, as practised by much of the industry, went badly wrong. Basic assumptions must be re-examined.

Most importantly, there is the notion that stocks do best in the long run. This is true, but after two bear markets in a decade, it is of much less practical use than people thought.

Even with the rebound, putting everything into stocks and waiting for “the long run” to bail you out of difficulty is no longer viable. Savers need to have more than “the long run” to protect them from the volatility of stock markets.

Second, we must now reject the notion that risks can be traded off against each other on the assumption that the correlations between asset classes are stable. Last year, efforts to limit risk by diversifying into alternative asset classes went disastrously wrong as they all fell together.

So the next few years will be dominated by a search for a better way to manage risk. Interest at the moment focuses on testing portfolios for specific “worst-case scenarios”, and on building asset allocation around a list of different risks (which might affect different asset classes in the same way), rather than different asset classes.

Some specific moves from hubris to humility are already evident. For a few years, the vogue was to look for “portable alpha” – to identify the portion of an alternative asset manager’s return that was down to true skill, isolate it, and then add to it “beta”, or the return from the market.

These strategies generated money for broker-dealers. But it was never as simple to separate “beta” and “alpha”. When things got bad, all kinds of strategies turned out to be exposed to the market, and went down with it. “Portable alpha” in effect meant making an even bigger bet on the direction of the market.

Now, the idea is to try to identify investor “skill” rather than “alpha” using ideas borrowed from behavioural psychology. The great investors tend not to be brighter or better informed than the rest. What sets them apart is their emotional intelligence – the ability to cut losses on losers, or to stay away from investment bubbles – and it may just be possible to derive this by looking for patterns of behaviour in their individual trades. Investment performance, or comparing to investment benchmarks, will not do it.

How to persuade the investing public to trust fund managers again?

The rebound is not making retail investors feel better. Instead, the mere fact that last year’s crash was possible seems to have had a lingering effect on confidence. And many large institutions who put their money into hedge funds are feeling duped.

For retail investors, the answer will revolve around a much simpler, possibly rather paternalistic offering, where savers are given very strong guidance on their asset allocation. It also makes sense to explore the idea that defined contribution pension plans should include an element of guarantees, to provide assurance that money is building that cannot be taken away.

As for hedge funds, their fees are going to come down. At the very least, they will have to clear much stricter hurdles before they start enjoying performance fees.

That is a painful issue, but the direction is clear. A tougher issue is transparency. Investors will demand to know more than hedge fund managers currently tell them, and rightly so. The presumption of trust has been lost for a while.

But true transparency is impractical for many hedge fund strategies that trade constantly through the day. And for many hedge funds, desperate not to let others see their plans, it is actively counterproductive. If, as a client, you have found a truly skilful manager, you really do not want their holdings to be transparent, public knowledge.

But if that form of transparency is not going to happen, hedge fund managers probably will have to provide much greater clarity about the strategy that is being pursued.

Armed with this knowledge, it should be possible to work out whether the returns they are reporting make sense, or whether they are diverging from what they said they would do.