Bloomberg BusinessWeek a few weeks ago ran a vulgar but highly apposite cover, in which a hedge fund’s claimed return pointed sharply upwards from a frat-boy fund manager’s abdomen while its actual return drooped feebly to the floor. Very clever, if uncouth. However Business Week covers are notorious contrary indicators, like that of 1979 headlining “the death of equities.” This could suggest a bright future for hedge fund returns, but I suggest a more likely possibility is that the unattractive investment vehicles are about to disappear altogether. Indeed investment management as a whole looks likely to suffer a very tough few years, followed by what might politely be called a strategic reorientation.
Peterson Institute President Adam Posen, writing in the Financial Times, claimed we have moved into a world similar to that of our Victorian forefathers. The world is no longer uni-polar or bipolar, there are several currencies in which international trade is conducted and there are no longer any “umpires” with superior wealth and force, compelling good international behavior. In the Victorian world, countries adhered to Gold Standard discipline, because it was the only generally agreed unit of account, but otherwise set tariffs and trade barriers according to their own national needs.
It’s an interesting idea, and certainly fits well with the loss of U.S. influence, both political and economic, over the last ten years. This column has itself remarked the remarkable similarity between the geopolitical positions of today’s China and Wilhelmine Germany, although I have my doubts that today’s rulers of China are possessed of as much calm good sense and respect for international order as the late lamented Kaiser Wilhelm II.
Posen’s thesis breaks down however when we regard the financial system of today, and compare it with that of 1900. The Victorian financial system was above all well-ordered, with financial titans like J.P. Morgan in New York and Nathaniel, Lord Rothschild in London steering the best business to an inner club of like-minded gentlemen, and leaving speculation and unsound deals to the minnows at the edges of finance, who were not trusted with large amounts of money or serious clients.
In addition, the floods of worldwide cheap money have raised equity prices and asset valuations generally to levels far above any sustainable value. In the long run, returns on bonds and stocks are not sufficient to attract capital, while the costs of such assets as housing, especially in major financial centers, and of some commodities such as oil are beyond the capacity of buyers to pay for. In this respect, the current market environment is nothing like the relatively staid world of the Victorian Forsytes, in which valuations were solidly defined and investments yielded their moderate returns only over long periods. Instead it is like periods of extreme speculation, such as the last year before the 1873 and 1929 crashes, the peak of the 1845 Railway Mania or the last inflating moments of the 1720 South Sea Bubble.
The investment management business likewise resembles that of the late 1920s, in which fly-by-night operations and pyramid schemes proliferated, each with higher fees than the last. Typical was the pyramid of investment companies launched by Goldman Sachs in 1928-29, the Goldman Sachs Trading Corporation, the Shenandoah Corporation and the Blue Ridge Corporation, each of which held majority stakes in the next company and was launched at a large premium to net asset value. These were essentially hedge funds, with the same taint of financial high fashion causing investors to apply for shares sold at grossly excessive prices (rather than, as in the case of hedge funds, to pay grossly excessive fees to the managers – in the 1920s the sponsors took their returns in the form of capital premiums up-front rather than annual largesse.) In the crash, the price of Goldman Sachs Trading sank from $280 per share to $1.25; the same fate may lie ahead for some of today’s best loved investment vehicles.
As with the Goldman Sachs vehicles of 1928-29 and the Mississippi and South Sea schemes of 1719-20, the spirit of speculation has drawn far more money into hedge funds and private equity funds than their relatively modest investment opportunities warrant. In the case of hedge funds, the opportunities for arbitrage between different areas of the capital markets are intrinsically modest, providing truly superior returns at first, but even by the time of the Long Term Capital Management collapse in 1998 giving investors far more risk than return.
In the case of private equity funds, opportunities existed in the 1980s, when substantial sectors of the U.S. economy were dominated by medium sized companies with traditional management and balance sheets. I was myself involved in one such venture in 1989-90, when I was able to bring the modest skills of a Harvard MBA and a reading of Mike Porter’s “Competitive Strategy” to the modular building business, then a highly fragmented industry dominated by simple building folk with no understanding of financial analysis or modern marketing management.
Needless to say, once the likes of Mitt Romney’s Bain Capital became nationwide operations with an ability to source deals throughout the corporate sector, the value added of simple MBA skills such as Romney and I brought to the table rapidly diminished. Since 2000, the only real value added of private equity investors has been access to cheap debt, in recent years at negative real costs, which they have been able to use to turn an uninspiring 20% or 30% return over 4-5 years on the investment into something with three digits, when sufficiently leveraged.
Currently the Standard and Poor’s 500 index is standing about 10% above its previous record, about double its level (adjusted for nominal GDP growth) of early 1995. (As discussed in previous columns, February 1995, when the stock market was roughly in equilibrium in terms of its long term trends, was the point at which monetary policy headed into the cosmos and all exuberance became irrational). There can surely be no doubt that at some point this bubble will burst and stock prices will head down into the pits, probably a Dow Jones Industrial Index valuation of 4,000 or so, as much below the adjusted-1995 equilibrium as today’s market is above. The market won’t rebound quickly from these depths, even though the economy will only enter a Great Depression II if the world’s politicians are exceptionally foolish.
Needless to say, operations dependent on leverage, like hedge funds and private equity funds, will collapse in that scenario, taking who knows how much of the world’s savings with them. Traditional equity and bond mutual funds, being sounder structures without leverage, will survive, but will become pretty unattractive businesses. The collapse in asset values would decimate their fees anyway, but the panic of simple retail investors who suffer the losses will cause a revulsion against risk among the investment public that will result in massive withdrawals, some of which will cause fund collapses through liquidity problems.
Other investment vehicles will fare little better, Leveraged ETFs will collapse for the same reason as leveraged hedge funds and private equity funds. However even conventional ETFs without leverage will find the defects of the ETF structure horribly exposed, as they are forced to sell their holdings in an atmosphere of panic, when their investors are themselves bailing out. As for defined benefit pension funds, their underfunding level will finally become irrecoverable, as their “alternative investment” hedge fund and private equity fund holdings collapse altogether and their conventional equity and bond holdings suffer huge and semi-permanent losses of value.
Following the crash, we will thus be in a world in which the current model of investment has collapsed, taking it with most of the assets of its unfortunate customers. In the last half century, by a gradual change, the “trustee” approach to investment management has been replaced with a Las Vegas approach, more akin to a casino croupier than to anything respectable. Following the downturn, the Las Vegas approach will be once more unacceptable, as it should be, and those hardy souls with assets they want outsiders to manage will be looking for trustees, who can above all preserve their assets and provide them with a modest return.
Only then will we finally have re-entered the Victorian world. Posen’s observations about the interactions between international business and nation states will remain valid, but in addition we will have replaced the gambling gunslingers of today’s investment management world with risk-averse trustees, seeking sound bond-like investments for their nervous and even more risk-averse clients. The world of 19th century investment will have rejoined the world of 19th century trade and diplomacy.
How will we pick these investment advisors? Quite simple – the ones who have truly absorbed the lessons of the crash and reverted to traditional investment practices will demonstrate their stiff-necked probity by a simple item of dress – the wing collar.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)