This is Part 4 in our coverage of Canadian Investment Review’s 2011 Investment Innovation Conference.
Read Part 2: Infrastructure investing
Speaker Richard Bookstaber, author of the book A Demon of Our Own Design, focused more broadly on the nature of innovation and what it has meant for financial markets during his presentation at Canadian Investment Review’s 2011 Investment Innovation Conference. He looked at the role derivatives have played as a risk management tool and how their use has evolved over the past 20 years.
“The derivatives markets have allowed investors to mold returns to meet their own investment objectives,” he said, adding that they have also generated a host of new risks.
Despite their original uses as a risk management tool, derivatives have developed “complexities and strange nonlinearities” that have made them less useful for investors—and infinitely more risky.
The biggest issue, Bookstaber noted, is that derivatives are being used for “gaming purposes”—in other words, they are being used to allow people to get around leverage restrictions and go short when they aren’t supposed to.
“That is why innovation over the last 10 years has become something different then it was 20 years ago,” he explained.
In the future, however, Bookstaber believes Dodd-Frank will improve the landscape: “The legislation will restrict the ability of banks to create complex derivatives just for the sake of doing it,” he said. Central clearing will also “pull derivatives back from the edge” and eliminate what has become an “informational asymmetry between the banks that make derivatives and the investors that buy them.”
Reduced complexity and increased standardization will eliminate the information “game,” said Bookstaber, and that will reduce innovation for the better in this space.
Watch: Richard Bookstaber talks about financial innovation
In the face of extreme market volatility, private markets such as infrastructure and private equity have been able to deliver better long-term returns according to Stuart Waugh, managing partner and managing director with Northleaf Capital Partners.
In particular, private equity has offered investors several structural advantages that come with direct and active ownership of private companies, including strong alignment of interests between management and investors and a committed capital structure that provides reliable funding.
“Private equity managers have demonstrated an ability to grow revenue and improve earnings margins through operational improvements,” said Waugh, adding that “this is critical at a time when normalized price-earnings multiples remain relatively high while future growth prospects remain uncertain.”
All of this means private markets aren’t subject to investor fear and sentiment, which Waugh said has accounted for major market swings in the last few years. Private markets are also becoming more accessible to small and mid-sized plans, as fund managers and advisors include “commingled funds and segregated accounts tailored to meet their individual investment and governance objectives,” he concluded.
Watch: Stuart Waugh discusses private equity
Caroline Cakebread is the editor of Canadian Investment Review. caroline.cakebread@rogers.com
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