Now, post-financial crisis, the search for true diversification is on in earnest. Super funds got the message that correlations move up and down with time, spiking to one in a crisis, just when diversification is really needed. Ryan-Kane, Watson Wyatt’s Hong Kong-based head of portfolio advisory for Asia Pacific, who was in charge of fixed interest at the former County Investment Management at the time of writing the paper, says portfolios will get more “specific” in the strategies they employ. “The Living Room Effect still worries me a bit,” he says.
“The theory that the developing world will consume the rest of the world out of trouble seems over-optimistic.” By “specific” Ryan-Kane means that fiduciary investors will move to fewer strategies which will genuinely behave differently to each other in different scenarios. But the linkages between strategies, as we now well know, make it increasingly difficult to find genuinely uncorrelated investments. One of the ultimate conclusions is that investors should own less equities – both public and private. They will have to look for other return drivers, rather than dividends, which are the last call on profits. “The more things you own, the more likely they will correlate to one in bad times,” he says.
“There has not been enough thought given to the possibility that the things that have been diversified into are not as diversifying as they historically were.” Until the 1990s the world had very different financial systems in the US and Western Europe and the former USSR and China. Then all the privatisations which took place in Russia looked very much like classic Wall Street M&A behaviour. And China completely reinvented itself along the same sort of Western model. There are more than 60 countries involved in the manufacture of the iPod, driven by very small differences in relative competitive advantage, Ryan-Kane says. Another driver of more specific strategies will be the desire for simplicity and clarity. Some investors in Asia could not explain to their stakeholders why they had invested in some of the things they did, such as CDOs which went to zero.
Ryan-Kane was in Australia last month to deliver big-picture presentations to clients at two dinners as part of the Watson Wyatt Ideas Exchange series. Even though his talk was very long term in its nature, the impact of the financial crisis was still clearly top of mind. “Why does it feel so strange?” he asks, echoing concerns of many investors that perhaps the world has not yet suffered sufficient pain for the dislocation caused by the crisis. Are the rebounding equity markets reflective of what’s really happening in the world? Ryan-Kane says that one of the perception problems is that a small part of the economy can perform in a dramatically different way to the vast bulk – which goes sideways most of the time, with most people doing the same thing they did yesterday – but that small percentage has a disproportionate impact on the economy.
The ups and downs in GDP are created by the huge volatility in very small parts of the economy. “The challenge for the fiduciary is that the people on whose behalf they are investing have a different ‘lifestyle volatility’ to the volatility of financial markets,” he says. Perhaps pension funds should invest more in real assets, such as farms, to better reflect the lives of their members, he suggests. And over time, are the funds acting as an investor or a saver? Their members, after all, go through the cycle of investor, saver and then dissaver. With more specific investment strategies and fewer equities, there will probably be a reduction in the amount of intermediation in the funds management industry. “You don’t need as many people in the chain for a more specific investment strategy,” Ryan-Kane says.
“Having the decision-making closer to the fiduciary or governance structure stands to reason.” He believes that conventional investment structures tend to serve managers rather than investors. There is likely to be more ‘clubbing’ by investors, which is evidenced by some of the state-based pension funds in Asia, or, more specifically, Chinese funds investing together in real estate. An interesting trend seems to be emerging as a reaction to the gating of some funds, such as mortgage funds and some hedge funds, to control the rate of redemptions during the crisis.
There was an early trend away from commingled vehicles, such as trusts, but providing segregated accounts for all investors has proved difficult and expensive for managers. So some funds have been looking to club together in traditional asset classes too, whereby they can invest alongside like-minded investors with similar time horizons. As the impact of the financial crisis seems to be (hopefully) fading, so too are early similarities drawn between current times and the Great Depression. A remaining similarity, however, is that after the Crash of 1929, Wall Street posted big gains in 1930 before resuming a longer slower slide.
Ryan-Kane says that the changes to the banking system starting in the 1980s meant that they moved from being lenders to originators, with risks associated with commercial property, as an example, shifting from banks to super funds. This led to the ploughing in of cornfields to allow the building of Mc- Mansions, turning semi-rural areas into new suburbs. The growth in financing allowed people to drag forward their consumption. The developing world got a glimpse of how the rest of the world was living. They may have been living in shanty towns but they shopped at giant new shopping malls.
But the development of a ‘shadow’ banking system, particularly in the developed world, to replace the traditional dominance of the banks has probably eased the burden of the crisis too. “We’re not seeing the same level of corporate failure as we would have a decade ago with the same sort of dislocation,” Ryan-Kane says. And the level of savings, thanks to pension funds, is far higher now than in 1929. The response to the early stages of the crisis by most professional investors was to do nothing, Ryan-Kane says, which proved to be the right decision (or indecision). But individuals, who dominated the financial investing world in 1929, tended to go to cash. In all, there is more ground for optimism than pessimism, he says.