It’s not all Greek to the hedge funds
At the start of the year it was fashionable to say that emerging markets were less vulnerable than in the past. The accumulation of official reserves, more stable capital flows and greater political stability were cited as reasons to be more optimistic about developing countries’ ability to withstand financial shocks.
Since early May, this cheery view has taken a knock. While the selling has not been wholly indiscriminate, all emerging markets have suffered. The question is why?
An interesting explanation for this, and for the more general return of risk aversion, was offered in a recent speech by Raghuram Rajan, chief economist of the International Monetary Fund. He argues that it is all about incentive structures in fund management and their interaction with monetary policy.
Mr Rajan gives several examples of why investors take more risks pro-cyclically when interest rates are very low and go into reverse when rates are high. One of the more interesting concerns their pursuit of alpha – returns in excess of those given for taking on market risk, or beta. Given that few fund managers are capable of generating alpha, there is a question about how they sell themselves to retail investors.
Mr Rajan’s answer is that when markets are awash with liquidity as in the period since 2001 it is relatively easy for fund managers to generate alpha through liquidity provision. For example, if a closed-end fund is trading at a significant premium to the underlying market, they can short the fund, buy the underlying market and hold the position until the premium dissipates. A vital pre-requisite, of course, is that continuing liquidity is available until the position closes.
This kind of liquidity provision is the activity that depends least on special managerial ability. Mr Rajan nicely terms it the poor manager’s source of alpha. Because positive excess returns tend to generate strong inflows while negative returns generate milder outflows, alpha boosts managers’ compensation when it is related to assets under management. This in turn helps explain why extremely loose monetary policy engenders “illiquidity seeking” behaviour in emerging markets and other high-risk assets.
The snag is that the poor manager’s alpha is quickly competed away. So managers hide the extent to which they are reduced to taking more beta risk by various stratagems. One is to assume “tail” risks in the credit derivative markets, which produce a positive return most of the time as compensation for a rare very negative return. As I have pointed out before, there is statistical evidence that this is common among hedge fund managers, whose short term reward structures make it very tempting to write the equivalent of catastrophe insurance.
Such behaviour is amplified when interest rates are low and reversed when conditions tighten. Proxies for risk aversion such as the Vix index of volatility appear to be positively correlated with the level of short-term interest rates and broad measures of liquidity. The Vix index also explains much of the variation in emerging market debt spreads. So the poor old emerging markets solve the fund managers’ problem by providing risky assets. Then they get it in the neck when developed world policy tightens.
Public relations audit
On both sides of the Atlantic, recent corporate scandals have largely been about cooking the books. Auditors have not emerged well, which makes it curious that their liability continues to shrink. A new book by legal academic John Coffee notes that the number of actions where US auditors are named as defendants continues to fall to record low levels.* The big firms are now trying to negotiate with corporate clients to preclude either court action by the client or punitive damages. True, they have to do battle with the new Public Company Accounting Oversight Board. But who would have guessed after Enron and WorldCom that audit liability would diminish?
In the UK, meanwhile, the company law reform bill will deliver proportionate liability to auditors, a boon enjoyed by their US equivalents since 1995. Those firms that shed their consulting arms are now, in contrast to the US, rebuilding them. Mr Coffee talks of the auditors’ move from a position of scepticism to “the problem-solving posture of the public relations specialist”. Certainly their lobbying skills are impressive.
*Gatekeepers: The Professions And Corporate Governance, OUP.
Invitation to steal
Speculation is mounting that the US Securities and Exchange Commission will retreat from rules introduced after the market timing and late trading scandals that require mutual fund boards to have 75 per cent independent directors and an independent chair. Can an investor watchdog really re-open the door to permit managers to steal from mutual fund investors? It would beggar belief.