Man or Machine - Do Pension Trustees Know?
The war between man and machine is no longer science fiction. As market turmoil continues, some experts suggest that "quant" funds may be making things worse. In "Blind to Trend, 'Quant' Funds Pay Heavy Price" (August 9, 2007), Wall Street Journal reporters Henny Sender and Kate Kelly describe the inadequacy of statistical models to accurately estimate "how risky the market environment had become." Losses by more than a few hedge funds are one result of automated trading.
In today's paper, New York Times reporter Landon Thomas Jr. adds that banks are starting to feel the pain as well and not just because of questionable credit issues in the sub-prime market. "Strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility."
Investors seeking to withdraw funds has exacerbated liquidity concerns. Leverage is another stated worry. By definition, borrowing money allows a trader to take a bigger position than would otherwise be possible. Short selling and derivatives are oft-cited as other leverage-inducing techniques. When times are good, leverage can magnify positive returns. The flip side is that leverage results in bigger losses when things deteriorate.
Leverage is not per se "good" or "bad." However, investors must understand the extent to which a fund levers its trading and therein lies the rub. There are multiple ways to measure leverage and its impact on reported performance is not well understood. (There is no universal consensus about how returns should reflect the "L" word.) Click here to see some examples recently added to the CFA Institute's site about Global Investment Performance Standards. (Choose Leverage/Derivatives from the pull-down menu.)
This blog's author adds "There is so much more work to be done in the area of disclosure and transparency. The amount of information that outsiders are missing is staggering. Even insiders may not have the full picture unless they know what questions to ask." Email us if you want a copy of "Deciphering Risk Management Disclosures" by Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM.
If pension fiduciaries thought that interviewing traders and portfolio managers was tough, try asking questions of R2D2.
