Can Institutional Investors Prosper in 2020? – Simon Paige
What can 2020 offer the institutional investor? As we leave 2019 low interest rates and over-priced equity markets have made the prospect of future returns bleak. Tens of millions of pensioners and savers face an uncertain future as firms such as GE announced the end to “final salary” schemes[1] and public pensions were estimated to be underfunded by $4.4 trillion.[2] That was last year. Does 2020 have to be the same? I want to suggest 2020 can be the start of lower risk and better return environment if funds build their own assets in the same way that venture capitalists build great companies.[3]
The new start begins with facing the obvious truth that low interest rates, over prices equities, and the BIG issue of chronic exposure to systemic risk all stem from the 2008 financial crisis.
Takeaway: Investment managers are not fighting multiple fires. All of today’s challenges have their origin in a single event.
The traditional 60/40 model was blown apart in 2008 as governments reduced interest rates and trillions of dollars of new money supply found expression in rising stock markets. These actions were undertaken to prevent financial meltdown through the insolvency of major financial institutions such as AIG and Citibank — a risk that since then has only increased.[4]
Systemic risk in the financial system is a structural issue where the solvency of leading institutions depends upon each other. Ironically this structural flaw is the result of the same institutions seeking to reduce risk through the use of derivatives. In their often cited paper Systemic Risk and Stability in Financial Networks Daron Acemoglu, Asuman Ozdaglar, and Alireza Tahbaz-Salehi have shown these mutual dependencies do indeed create robustness in the financial system when minor shocks such as default on a specific loan occur. However they also demonstrate that if the shock is large enough, for example the failure of a bank, the same network of dependencies actually escalate the shock producing the possibility of system wide collapse. A network that functions like this is called “robust yet fragile”.
“[As] long as the magnitude of negative shocks affecting financial institutions are sufficiently small, a more densely connected financial network (corresponding to a more diversified pattern of interbank liabilities) enhances financial stability. However, beyond a certain point, dense interconnections serve as a mechanism for the propagation of shocks, leading to a more fragile financial system.”[5]
Takeaway: Facing up to the single source of multiple challenges facing a portfolio leads to one utterly simple realization — to reduce risk and improve returns funds need to diversify outside the fiat system.
If the fire — expressed as low interest rates, overvalued stocks and painful exposure to systemic risk — are facets of systemic risk in fiat markets, the ONLY answer is to find alternative sources of value.
After 2008 understanding this need many funds did exactly that. For example the Harvard Endowment invested in a range of natural resources such as eucalyptus plantations in Uruguay and farmland in Brazil. The problem was that these assets have not performed well resulting in a $1 billion write down for Harvard.[6]
Takeaway: Funds need not only non-fiat diversification but sound returns a well.
That brings us to the idea of a fund building its own assets. The events of 2008 were also the stimulus for the invention of the distributed ledger (blockchain). As a proof of concept a digital currency was created. At this time of writing the currency has a market cap of $130 billion[7] and is the best performing asset of the decade.
The success of this proof of concept offers two great insights for fund managers. First, it reminds us of one of the fundamental and almost universally ignored principles of finance — that monetary value is generated by people. Not government or their central banks. Money is a human artefact like language. A return to this most basic understanding of money opens the door to new asset creation.
Second is the distributed ledger itself. Its use means that the value created by people does not need to be administered by a centralised authority. Financial assets, like the Internet, can be decentralised and hence robust (read: free from systemic risk).
We need to add a third ingredient to the mix — that people can maintain an asset at a specified value, a peg. The most obvious example of this is older than money itself — gold. Gold has been the basis of finance and the stability of currencies during the gold standard era because of its own stable value. What created that stability? Peoples’ need and desire for a stable value which could serve as a medium for exchange.[8]
With these three ingredients — people create value, a distributed ledger and people’s ability to maintain a peg — let us create a new asset using the following recipe:
· Take a proven hedge fund strategy, preferably long/short to be agnostic of market conditions, preferably based on non-fiat assets such as commodities to be free of systemic risk.
· Irrevocably time-stamp trade signals before they occur to prevent fraud.
· Simulate trading rather than actually trade assets to remove counter-party and systemic risk.
· Publish trading results.
· Create a digital asset whose sole purpose is to track the value of the simulated returns.
· Go public in declaring one’s stake in the asset as a means of building confidence and encouraging uptake.
· Discount early tokens as a capital efficiency measure so that seed investors put in the least capital for the greatest gain potential.
· Once liquidity is available drawdown on assets according to need.
· Mitigate risk by starting/investing in more than one such asset.
The result:
· Multiple assets in the portfolio each with independent value outside the fiat system.
· Better return potential than the existing hedge fund structure because of token discounts and zero fees.
· A return to genuine diversification and sound risk management.
The perceptive reader will notice that while the proposal may sound radical it is actually simply the use of the venture capital value creation model applied to the creation of financial assets instead of companies.
Risk is handled the same way, through diversification and capital efficiency. The only real difference is that creating an asset requires active participation on the part of the fund by declaring their interest in their creations. By acting like a VC funds activate the most successful value creation model over the last 20 years.[9]
Takeaway: Institutional Investors can build their own assets with lower risk and greater return potential than the current investment environment.
This build-your-own asset model has been developed by me over the last two years. Called Self-Managed Investments (SMIs) details of their development is summarised in a series of articles on Medium.[10] A long/short Bitcoin strategy is already operational.[11] Others, including a long/short crude oil and long/short coffee strategies are being incubated.[12]
The recipe combines the know-how of the best performing asset of the decade with the business model of the best performing asset class over the last two decades. The assets created can carry orders of magnitude less risk than their fiat based counterparts with greater return potential. In other words SMIs enable 2020 to be the start to restoring robustness a portfolio by addressing the major structural issue built into the current fiat system.
I hope this article has provided a fresh perspective for a new year. All the resources for creating SMIs are already available to fund managers. They have evolved from exactly the same 2008 event that is currently putting all the stress on portfolios. What kind of future are you looking for in 2020 and beyond?
[1] https://www.ft.com/content/c95deea4-03e2-11ea-9afa-d9e2401fa7ca
[2] https://knowledge.wharton.upenn.edu/article/the-time-bomb-inside-public-pension-plans/
[3] https://medium.com/@simonpaige/managing-the-greatest-risk-of-all-what-portfolio-managers-can-learn-from-venture-capitalists-dbee206a9788
[4] http://www.kenton-dau.com/uploads/8/3/1/8/8318442/lehman_brothers_and_bitcoin_%E2%80%93_a_potent_combination_for_stress_testing_the_robustness_of_your_portfolio.pdf
[5] https://www.nber.org/papers/w18727
[6] https://www.barrons.com/articles/harvard-endowment-is-doubling-down-on-private-equity-51571929202
[7] https://coinmarketcap.com/
[8] https://medium.com/@simonpaige/discipline-in-currency-maintaining-a-stable-value-a1f1426ef6fd
[9] https://www.cambridgeassociates.com/wp-content/uploads/2018/10/WEB-2018-Q2-USVC-Benchmark-Book.pdf
[10] https://medium.com/altcoin-magazine/introducing-self-managed-investments-smis-a-digital-hedge-fund-designed-for-portfolio-4dc043b03076
[11] https://bitcoinenhanced.io/
[12] http://www.kenton-dau.com/smi-incubator.html
Published at Tue, 17 Dec 2019 21:21:23 +0000
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