Alternatives are a risky business, according to Professor Harry Kat.
London-based finance academic Harry Kat compares the unfolding credit crisis to a bunch of drunken revellers leaving a party too late—it’s not a pretty sight. But it’s alternative investments that have him worried. In fact, he thinks pension funds should avoid them altogether. A professor at the Cass Business School, Kat’s focus has been on structured equity derivatives and alternative investments. He sat down with us to answer our questions on alternatives, the credit crisis and how investors sell themselves short when it comes to taking on risk.
What’s the current economic situation in the U.K. versus in Canada? Are investors suffering the same contagion from the U.S.?
Problems all over the world are more or less the same because they are all caused by the same phenomenon. That is, basically, the fact that we should have had a recession in 2003. People, however, just kept borrowing like crazy and interest rates got turned right down. Some cultures are more prone to borrowing than others—look at continental Europe, for example. It’s also a structural thing. For example, in Holland, mortgages are 10-year, 15-year fixed [rate], so people experience 4% interest rates and really don’t care where they go. It’s all fixed.
What about Canada?
Canada and the U.K. are pretty much alike in terms of mentality, [and their] problems are very similar. Solutions are easy: the whole thing needs to shrink.
I like to use a party example with my students because it hits close to home. By 11 p.m., you have had more than enough, but you are not going home. You should go home, but you’re not. We are still at that same party that we should have left in 2003. We should just have had a nice old-fashioned recession [then]. But the industry said, ‘We are in the biggest bull market ever.’ And then the world changed because the interest rate went down to 1%.
After the interest rate was put down to very low levels, people continued to do what they do naturally. People cranked up their lending businesses, and citizens borrowed and spent. But you can’t keep doing that because your income doesn’t grow with it.
We need to shrink back to 2003 levels because that is when markets were in a natural state. Entire bank balances need to shrink; personal debt needs to shrink—[it] shouldn’t have been this way. This is a truly global thing.
Are pension funds concerned about risks associated with alternatives?
They should be, because I can’t think of one alternative investment that they should be investing in at the moment. It’s always been hard, but at this point, why not solve the big picture first? Why not get rid of all of the uncompensated risks that you are carrying on your asset side and make sure you get the biggest return or bang for your risk buck? Get the bottom line right first.
I think, also, that under the influence of these new low interest rates, people have gone return crazy without looking at the risks involved. They have let themselves get locked up for years. They have accepted that they had no idea what their investments were worth in the first place. They have invested in risks that turned out [to be] totally different than they were to begin with.
If someone comes to you with a forest [saying], ‘Look, timber is the new hedge fund—buy now,’ you have to think about it. What is this? What am I buying? Just a load of wood. But what is wood used for? Why does it have value? It’s not because they build ships from wood anymore; it’s used to build houses now. So what happens [to houses] when the economy goes down? Well, they build less of them. What happens to the demand for wood, to the price of wood? And what happens to your timber investment? It goes down—exactly at the point in time when everything else is going down as well.
So what benefit do you get from investing in something like that? It is just more of the same. It looks different, but instead of a nice stack of paper, you have a whole forest. But the value of the paper starts to go down, then the value of your forest starts to go down. So, from that perspective, you might as well have more paper. It’s a lot easier.
What are the main barriers holding back plan sponsors from investing in alternatives?
Hopefully, common sense and all of the drawbacks you are taking for granted if you invest in something like that. You talk about fees. You talk about transparency—not knowing what [managers] are doing with your money and not knowing what your investment is worth. Style drift. A guy that claims to be a merger-arbitrage trader—then there are no more mergers, so he decides to trade convertibles for a while but forgets to tell you about it. Those are the sorts of risks. You name it.
There are so many drawbacks that people take for granted when they invest in anything that calls itself an alternative. You have to wonder if it’s worth it.
I am a big fan of liquidity; I want to be able to move in and out whenever I feel like it, at a good price. Market price—you are giving up [that luxury] when you go into alternatives. You won’t have that anymore. And, of course, people say, ‘I don’t care. I am a long-term investor; I am not here to move in and out.’ [But] it’s kind of an awful thing to have, don’t you think?
It’s kind of like a pre-nuptial agreement. People get married and say, ‘We love each other so much; we don’t need that.’ Not now—but maybe later—it’s convenient to have one. Liquidity is the exact same thing. Anybody you ask says that they don’t need it, but that is because [if] you haven’t even gotten into a loan, you [don’t] think about getting out again.
But when you do, you want it to be a hassle-free process. You want to say, ‘Listen, I want out!’ and then get a good price and get it into your bank account three days later. And not receive a letter—after you called the manager three months ago [saying] that you wanted out—saying, it wouldn’t be fair to the other investor if we let you out because markets are bad. And to generate money that we need to pay you, we would have to sell at really bad prices and the other investors would have to take the hit just because you want out. So, no, we don’t think we are going to let you out for a little while.
Who needs that? If I make 10% extra on that investment a year for a couple of years, I make 30% more than anybody else. Then I would put up with it. But you don’t—you are lucky if you make the same as a smart package of five futures. [So] why would you? Think about it.
Which alternative assets are plan sponsors shying away from and which are they embracing?
That’s really hard to say. People will go for the ones that do best over this crisis, and they will walk away from the ones that did the worst. Probably, they should do the opposite.
You think so?
History is not a good guide for the future when it comes to investments. People have done badly during the crisis and we ask ourselves why. There are perfectly sound reasons for it—and if it’s something that is not present in the markets anymore, then you shouldn’t expect it to be bad any longer. If somebody levies up a lot and can’t continue to get money, this will probably continue.
There is no money; the world economy is shrinking. Funding is a big thing—if somebody has got into a problem because they couldn’t get the funding right, you probably have more reason to stay away. Short-selling is going to get more difficult and more costly, so if someone uses a lot of short-selling, that’s probably not going to be the guy to go with either.
That is how you have to look at it: study every case by itself to see why or what was the reason it did so well and, equally, the reasons why it didn’t do well. It’s only after a serious bit of due diligence that you can make decisions. You have to visit every one of [the managers], talk to every one of them. Ask them the right questions and think about the right answers.
You can’t rely on the rest of the market to do it for you, like you can with equity. With equity, there are millions of people who are reading newspapers and trying to figure out bits and pieces about companies, then it all falls back into that one price. So even if you don’t do your homework, there are millions of other people doing it for you.
But in alternatives, that is not the case. There is nobody else doing your homework for you. You have to do it all yourself, and it’s what a lot of people conveniently like to skip over. There is a lot of work to be done if you want to be good at this sort of thing.
Is that a governance problem?
No, it’s an investor’s problem. [Investors] have lost the appetite and maybe even the will to do their homework. They have databases and optimizers and all that sort of stuff, and they just like to press F3 and get the optimal portfolio. That’s it. We are investing!
Well, you know, not really. There is more to it than that. Those who still do their homework, those like Warren Buffett—those are the men to be watched.
Jennifer Hughey is editor, conferences and online events, with Benefits Canada.
jennifer.hughey@rci.rogers.com
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the Spring 2009 edition of INNOVATE magazine.