Even if you put all your eggs into different baskets, as long as you are long in eggs you cannot escape systemic risk.
—Not attributed to Harry Markowitz
T
here has been an enormous increase in the amount of pension-related savings over the last 15 years driven by demographic trends in the United States and other industrialized nations, especially Japan, as the Baby Boom generation prepares for retirement. It is a trend expected to continue well into the future. Across all OECD (Organisation for Economic Co-operation and Development) countries, pension fund assets have increased rapidly in size and totaled almost$18 trillion in 2005, up from$13 trillion in 2001. (OECD 2006, 3). Collectively, these assets represent approximately 88 percent of the annual GDP of these countries.The United States has a major influence in these trends. In 2005, U.S.
pension fund assets amounted to $12.3 trillion, up from $9.7 trillion in 2001, representing 99 percent of GDP, up from 96 percent in 2001 (OECD 2006, 3).
Unlike many other OECD countries that primarily invest in bills and fixed income securities, the United States just has approximately 15 per- cent of its pension fund assets in these credit instruments (approximately
$1.8 trillion), and almost 65 percent in mutual funds and equities (OECD 2006, 7). These credit instrument assets are spread between the public sector local, state, and federal pension funds (collectively$750 billion at the end of 2005), the private sector pension plans ($659 billion) and life insurance pension plan reserves (Federal Reserve 2007).
59
60 MANAGING CREDIT RISK In addition to these pension-related credit instrument assets, as we showed in Table 3.1, professionally managed investment funds such as mu- tual funds, money market mutual funds, closed-end funds, and exchange- traded funds controlled another $3.7 trillion in credit instrument assets.
Clearly these portfolio managers have an influential role to play in the credit markets.
F I X E D I N C O M E P O R T F O L I O S T R A T E G Y
As trillions of dollars have accumulated in pension funds and mutual funds, an entire industry has sprung up to manage and invest this money. Profes- sional money managers compete with one another on the yields that they can produce for investors as well as on the price of their services. In both respects, the differences between individual managers may be quite small.
Money managers can invest in a wide range of instruments from equities to real estate, but they really have just two basic ways to make money. To the extent that they are able to buy low and sell high, they can earn money through price appreciation. To the extent that they are able to lend money at a reasonable rental, they can earn money by taking credit risk. The latter strategy places them in a position very similar to that of a bank, finance company, or insurer.
It is in their approach to handling credit risk that professional money managers differ dramatically from the cottage industry players such as banks and insurance companies. While a bank or insurer focuses primarily on the individual risk, a money manager focuses onbothindividual risk and portfolio risk—constructing a diversified group of investments and trying, as quickly as possible, to sell any holdings that are not performing well or are not expected to perform well. This approach is generally known as total return portfolio management. While some money managers se- lect securities through a fundamental value/bottom-up process, others com- bine a top-down view of the economy with a bottom-up view of relative values.
Money managers make use of industry and company research in at- tempting to select the best investments possible. Let us take for example, Standish, Ayer and Wood, a successful investment management firm based in Boston. This firm is historically known for its successful track record in sector/security selection (65 percent of its historic returns are attributed to security selection and the other 35 percent to the firm’s interest rate out- look). In its investment approach, Standish, Ayer and Wood balances classic credit analysis, collective credit judgment, and constrained optimization. It looks, in particular, for companies whose credit rating may be upgraded.
The Portfolio Managers 61 As Howard Rubin, director at Standish, Ayer and Wood explains in an interview with the authors:
From a sector perspective, we are comfortable in all sectors of the marketplace and do not base our decisions on just a select few.
Based on the perceived relative value of these broad sectors, we buy the cheapest securities, hoping their value would be recognized by the market place and enhanced—thereby filtering down in terms of performance to the client.
Here is how David Stuehr, another of the firm’s directors interviewed, describes the bond acquisition process:
The initial theory can come from many sources. It can be triggered from the trading desk—say, an A-rated bond is trading like a BB.. . . There is always some reason things are trading out of whack. An- other example is the current tobacco litigation. How is that going to affect the billboard companies used by the tobacco companies?
The idea could come out of screening from our data warehouse.
Here we maintain company financials, yield spreads, and company analyses such as ratings and S&P plus, minus, and watch list. We can slice and dice company data coming from many diverse sources.
Any of this gets you focused on a fundamental idea.
We look at the financial ratios such as traditional interest cov- erage and free cash flow. Are they improving? We construct a pro forma model. We want to know what the downside is. We try to re- late the company to the overall state of the economy. In some cases, such as a paper company, the management will tell you the sensi- tivity of their revenue streams to external variables so we can come up with our own scenario. For others, such as a conglomerate, this is more difficult. Take Koppers, for example. As a conglomerate, that company is into many things: treating railroad ties and tele- phone poles, supplying industrial coke for steel. You cannot even talk about sector sensitivity with their management; they may not know it. In this case, we try to assess the revenue and profit impact of a 5 to−10 percent recession.
We also look at market capitalization. We learned early that the equity analyst knows the company better than the bond analyst. It is not that they are smarter than bond analysts, but just that they have to follow the companies more closely and have fewer companies to follow. We then rate the companies based on the chances that
62 MANAGING CREDIT RISK they will get upgraded. We set sector limits based on qualitative and subquantitative judgment.
We then assess the credit positives and the credit negatives for the company, including its size and leverage, both financial and operational. Then we analyze relative value; sometimes you will find that the security is not available at the price that was indicated.
. . .The individual analyst will set up the idea and then build support for it. We build consensus and once it is reached, the decision has our collective support.
The decision to buy/hold/sell does not stop there. Every security has to satisfy what Howard Rubin calls “the capital rationing criterion.” That is, is the investment in the security the best use of capital? Securities in each rating tier are continually ranked according to spread, duration, and potential for a credit quality upgrade. Collaborative decision making does not seem to slow the process. Caleb Aldrich, director at Standish, Ayer and Wood, notes in the interview:
But we will not hesitate to challenge each other. Over time, we have built up a level of mutual confidence and respect as we have sought to enhance return to the client. It is understood that everything that we attempt is related to that. For this reason we will not hesitate to challenge each other if necessary to maintain the leading edge we have. That does not mean that we will dismiss ideas out of hand, but we do turn down an idea if it does not fit in with our risk/return perspective.
Professional investment management firms operate with far less man- power than do banks, and, in general, they have less confidence in their ability to select the right borrowers. Disciplined selling is therefore a critical aspect of their approach. The practitioners of total return portfolio man- agement measure their success not only by the skill with which they identify good investments, but also by the speed with which they recognize and jetti- son bad ones. As Caleb Aldrich observes, “We do have the benefit of having liquidity and marketability on our side. We can afford to make mistakes because we can exit quickly—before the market realizes that it is a mistake.
In a lending situation, a bank does not always have that option.”
For the vast majority of professional portfolio managers, diversifica- tion is the key to managing credit risk. Following the precepts of modern portfolio theory, money managers try to structure a portfolio that is di- versified by every conceivable variable—sector, geography, duration, and type of instrument. In doing so, they are careful to avoid excessive portfolio
The Portfolio Managers 63 concentrations. If any one security should begin to lose value, it will be counterbalanced by a great many others that have retained their value.
As a corollary to the diversification axiom, money managers generally stay invested in all segments of their chosen market. If they do not like the immediate prospects, say, for mortgage-backed securities, they will lighten their allocation to this segment rather than exiting from it altogether. Pro- fessional managers generally stay within the context of the market in which they are investing, observing the relative weightings of its various segments in the index against which their performance is measured. When, for exam- ple, they decide to overweight a portfolio in corporate bonds, they regard the decision as a conscious bet on this sector. Their focus is on relative rather than absolute performance: The primary objective is to outperform the index—and other money managers.
Although the benefits of diversification have, by now, been well docu- mented, it does remain true that, in diversifying, a manager typically passes up some investment opportunity in order to reduce risks, and he or she may invest in some things that he or she probably would not select in an undiver- sified pool. At the extremes, a few money managers, such as hedge funds, may ignore the principles of diversification in an effort to maximize returns.
However, the experience of professional investment managers has generally been quite good. It is demonstrably true that modern portfolio theory helps to mitigate investment risk and to dampen portfolio volatility.
Practitioners of total return management effectively avoid one of the fundamental flaws of the banking industry—the tendency to hold on to bad loans for too long. When a borrower gets into trouble, a banker may well take the time to hear the company explain its situation and plan of action. Under some circumstances, a bank may even agree to lend additional money. They do this because bank loans have generally been hard to sell in the public markets. If a loan deteriorates in quality, a bank may have few alternatives to participating in its restructuring. A portfolio manager, by contrast, will generally try to get out of a deal at the earliest sign of weakness. As a result, pension funds and mutual funds have rarely suffered the kinds of large losses that banks experienced in recent decades.1 While banks emphasize their relationship with the customer through good times and bad (with varying results), fixed income portfolio managers never lose sight of where they stand relative to the investment that they have made.
Money managers are able to take this tack because they do not allow portfolio concentrations to become so great that the liquidity and mar- ketability of their securities would be affected. Selling any one holding will cause only a small loss, and the proceeds of the sale can then be used to purchase other securities. Portfolio managers typically have no interest in learning how a stressed credit plans to get back on its feet. Such loyalty to
64 MANAGING CREDIT RISK the borrower would make little strategic sense. A fixed income security pro- vides a relatively small stream of interest income. Investing in such securities at 100 cents on the dollar is an activity that offers relatively little upside.
Typically, a fixed income manager has few opportunities to recover a large loss. It is therefore more rational to sell distressed securities as quickly as possible. At the right price, there will always be buyers. Other investors will be willing to pay 60 or 70 cents on the dollar for such bonds because there is an upside for them—a chance to see their investment appreciate.
Fixed income portfolio managers differ from bankers in other impor- tant respects as well. They invest in publicly rated securities for which there is generally a liquid market, and they are required to mark their invest- ments to market. When a credit deteriorates, a portion of their portfolio will decline in value. This market discipline strengthens a money manager’s motivation to sell. Bankers, by contrast, do not mark loans to market; as long as they continue to receive current payments, they classify a loan as performing—even if the borrower is barely staying afloat.
Banks and pension funds also operate under different regulatory regimes. Indeed, society looks to them to serve somewhat different pur- poses. While both kinds of institutions are expected to safeguard people’s savings, banks are also expected to provide financing to meet the legitimate needs of businesses and individuals. For many people, banks are, above all, a source of liquidity, mortgages, and working capital loans. When banks tighten their credit policies and slow the flow of financing, some Americans promptly contact there representatives in Congress to complain about the resulting credit crunch. By contrast, virtually no one expects pension funds to carry the burden of financing American enterprises. When a pension fund declines to buy a particular company’s bonds, the firm’s executives do not call Congress to complain. Indeed, under the terms of the Employee Retire- ment Income Security Act of 1974 (ERISA), pension plans are legally bound to put the interests of their participants first. If the officers of a plan allow other interests to intrude, they may be guilty of breaching their fiduciary responsibility to plan participants.
Despite the generally positive record, some professionally managed, fixed income funds have encountered problems. In the case of certain junk bond funds and real estate funds, for example, diversification has been inef- fective because the portfolios were too concentrated within a specific segment of the market. Economic problems affecting the entire segment caused large losses. Funds that are highly concentrated in a particular geographic region (such as country funds) have also experienced sizable losses.
More generally, it should be noted that portfolio diversification has largely been a matter of intuition and common sense rather than of hard
The Portfolio Managers 65 science. To date, relatively little serious analytic work has been done on the correlations among different industries and among various types of securi- ties. Lacking these tools, portfolio managers have been unable to realize all the potential benefits of diversification. Pension funds, mutual funds, and unit trusts may therefore gain a great deal from future advances we expect to see in portfolio theory. These are discussed at length in Chapters 17 through 22.
A second problem for portfolio managers derives from the security se- lection process itself. Most money management firms are overmuscled in portfolio theory and undermuscled in security selection. This is evidenced by the number of analysts they employ relative to the size of the marketplace that they have to address on a name-by-name basis. As a result, they are liable to purchase securities that may potentially lose value because of declin- ing credit quality. While disciplined selling generally protects them against catastrophic losses, fixed income funds may nonetheless be accepting an unnecessary volume of small losses.
To address this problem and also to take advantage of investment op- portunities in the growing market for bank loans, high-yield corporate debt, and the debt of emerging countries—all of which involve credit risk (and yield) of higher than customary magnitude—some large investment firms have begun to incorporate credit skills that are normally associated with banks. Companies such as Fidelity Investments have begun hiring profes- sionals trained at banks to help them design credit systems that combine individual credit analysis with portfolio management skills. Banks, mean- while, are acquiring some of the portfolio skills normally associated with money managers. Whether in the hands of a bank or a money manager, the combination of the two approaches should lead to much more effective management of credit risk.
H E D G E F U N D S
Any discussion of credit instrument portfolio managers and the credit mar- kets today needs to include the role of hedge funds because of their significant impact and influence. When the first edition ofManaging Credit Riskwas published in 1998, there were approximately 3,000 hedge funds, up from approximately 600 in 1990, but many less than the 9,228 now estimated to be in operation (Wastler 2006).
To a significant degree over the last 10 years, many of the changes in the credit markets and improvements in terms of innovation, liquidity, and risk dispersion have been driven by the hedge funds. They are estimated to
66 MANAGING CREDIT RISK manage approximately$1.6 trillion (FSF 2007, 8)4but they are responsible for a much higher share of turnover in many markets, in particular the credit derivatives market. “In 2005 the consulting firm Greenwich Associates esti- mated that while hedge funds accounted for 15% of trading volumes in the U.S. fixed income markets, this proportion rose to 45% of trading in emerg- ing market bonds, 47% in distressed debt, and 58% in credit derivatives.”
(FSF 2007, 8) Movement between the funds is very dynamic, with the launch of some 1,518 in 2006 and the liquidation of 717 in 2006. Their growth has been a global phenomenon, still concentrated primarily in the United States, which has 65 percent of the assets under management, compared to Europe with 24 percent and Asia with 8 percent as of 2006, but down from 2002 when the United States had 80 percent of assets. As we have seen with other financial organizations, there has been a trend towards concentration, with the 100 largest funds representing 65 percent of the industry total compared to 54 percent in 2003. The very largest global fund groups now manage$20 to$30 billion each or more (FSF 2007, 8).
William White, Economic Adviser and Head of the Monetary and Eco- nomic Department at BIS, in a speech in early 2007, commented that “unlike the hedge funds of the 1940s, today’s hedge funds are far from hedged.
Rather, operating with a very few investment restrictions, but different
“styles” (principal investment strategies), they commonly take speculative and leveraged positions in the pursuit of absolute target rates of return to which the manager’s compensation is generally related. Whereas, hedge fund investors were originally wealthy individuals, in recent years hedge funds have attracted the interest of institutional investors, including pension funds and insurance companies. This has led to the greater professionalism and “institutionalization,” especially of larger hedge funds” (White 2007).
Unlike the portfolio investors we have discussed previously in this chap- ter, who seek to create efficient portfolios through careful analysis and diver- sification, hedge funds are outright risk takers seeking only commensurate or better rates of return for the exposures they take on. In doing so, they help reduce and spread systemic risk but in the process they create their own sets of risks. As organizations they themselves are highly leveraged and they tend to focus on complex and illiquid products and markets where the technical challenges of risk measurement and management are high. As we saw with Long-Term Capital Management in 1998, even the very best management and trading teams with substantial capital can be fatally damaged if there is sustained high stress and adversity. In William White’s words, they have contributed much of the “grease,” which has helped to grow the financial system so successfully but care must be taken so that the hedge funds under extreme events do not become the “sand.”