book reviews
Extending the Canon: New Titles
The Origin of Financial Crises | The Snowball |
Managing Hedge Fund Managers
Animal Spirits | Panic | Leveraged Finance | Pioneering Portfolio Management
The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy
by George Cooper. Vintage. 2008. 208 pages. $12.95
Dr. George Cooper, a former head of fixed income at JPMorgan Chase and currently a principal at Alignment Investors, argues that credit excesses are the wellspring of financial crises. Cooper’s book is a vigorous indictment of the EMH (efficient market hypothesis), in which laissez-faire economic theories are applied to financial markets. He skillfully dismantles the prevailing theoretical paradigm, which has failed to predict or explain the recent carnage in financial markets, and suggests an alternative based on economist Hyman Minsky’s financial instability hypothesis, which Cooper contends better fits recent market facts. Applying Minsky’s theory, Cooper proposes modifications of the mandates of central banks and suggests prescriptions for the current economic malaise. The book is a deftly reasoned contribution to the torrent of criticism surrounding orthodox financial market theories.
Cooper attacks the EMH’s most important premises and exposes its logical contradictions. He contends that the obvious trail of booms and busts in financial markets challenges the central assertion of the EMH. In fact, says Cooper, no “invisible hand” orders markets to the optimal allocation of resources and to the most efficient setting of asset prices. Repeat cycles of credit creation and destruction cause asset markets to behave differently than goods markets driven by supply and demand. Bubbles and crashes are organic aspects of asset markets, and financial instability is the price of economic progress; no market equilibrium exists.
Cooper provides a handy primer on the origins of money, the credit-creation process as a driver of wealth generation, and the expected role of central banks in dampening the effects of credit cycles. He contends that policies that perpetuate debt-fueled binges are the unfortunate result of misplaced faith in the wisdom of markets, combined, ironically, with deliberate intervention to protect us from markets’ penalties. By repeatedly bailing out debtors via monetary accommodation, while failing to puncture inflating bubbles, policy makers defer the inevitable implosion that results from the accumulated burden of debt.
Cooper contends that policies that perpetuate debt-fueled binges are the unfortunate result of misplaced faith in the wisdom of markets, combined, ironically, with deliberate intervention to protect us from markets’ penalties.
Markets are not efficient. They operate in a feedback loop with the real economy, cycling into credit-induced manias that produce “Minsky moments,” or regime shifts, when those bubbles disastrously collapse under their own weight, bringing on painful periods of deflation reinforced by the Keynesian “paradox of thrift.” Irrational investors do not cause asset prices to oscillate between unknowable extremes, says Cooper, as he takes a swipe at the behaviorists who tried to bridge this logic gap for critics of the EMH. Rather, prices gyrate thanks to self-reinforcement; that’s the reason they’re not normally distributed, despite the assumptions of many asset-pricing and risk-management models.
Cooper has a practitioner’s familiarity with markets, and an academic’s ability to weave competing ideas into a coherent alternative to the EMH. He argues that the roots of all financial crises lie in our belief in our flawed theories, in the inevitable cycles of credit creation, in the markets’ inherent feedback loops, and in the amplifying role played by central banks with their feet on the monetary accelerator.
If Cooper is right, central banks’ expected role in mitigating credit cycles needs modification. Since perfect stability isn’t possible, it shouldn’t be sought. Bankers should encourage frequent corrections that purge credit excesses, disciplining excessive risk taking. Central banks should behave symmetrically, pricking asset bubbles. Bankers must discriminate between recurrent credit cycles—a necessary evil—and truly dangerous inflation pressures caused by monetary debasement.
Applying his thesis to solutions for the present financial crisis, rather than deterrents to future crises, Cooper is less convincing. Even with an extensive revision of our theories of financial market behavior, policy makers have a frustratingly short and familiar list of options: let debt deflation run wild, create another credit bubble, or soften the landing with the printing press. Even armed with Cooper’s new and well-articulated insights, we are still reliant on conventional policy options when confronting the epic debt built of our historical profligacy.
Kathleen DeRose, CFA, is a senior managing partner and head of portfolio management and research at Hagin Investment Management, a long/short equity manager.
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The Snowball: Warren Buffett and the Business of Life
by Alice Schroeder. Bantam.
2008. 976 pages. $35.00.
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There’s no shortage of Buffett books out there. For insight into his strategy, McGraw–Hill’s 2008 edition of Benjamin Graham’s classic Security Analysis, which features an introduction by Buffett, is the way to go. For behind-the-curtain revelations about Berkshire Hathaway’s annual meetings, nothing beats Jeff Matthews’s Pilgrimage to Warren Buffett’s Omaha (McGraw–Hill 2008). But Alice Schroeder’s The Snowball gives the fullest, most nuanced picture of both the personal and professional man.
Schroeder dwells with pleasure on Buffett’s childhood, mining his early biography for clues to his later development. An inveterate collector, he hoarded coins, stamps, and even bottle caps. It was by studying the bottle cap collection that the young Buffett learned to identify which brands were the biggest sellers and which affected trends in the marketplace. While most people know about Buffett’s newspaper route, his very first profits were actually earned from buying packs of gum from the family grocery store for three cents, then selling them door to door for a nickel. He was born with a gift for making profits, and into a family that supported the potential he showed for brokerage.
Schroeder whisks the reader briskly through Buffett’s college years at Penn (1947–1949), the University of Nebraska (1949–1950), and business school at CBS (1950–1951), where he had his fateful meeting with Graham. With money raised from friends and family, Buffett began investing in what he called “discarded cigar butts with one more puff”—small-cap stocks trading at a significant discount to intrinsic value. It wasn’t until 1959, when he crossed paths with Charlie Munger, later to become a crucial colleague of Buffett’s at Berkshire Hathaway, that he started to buy great businesses at good prices.
Of all Buffett’s acquisitions, Schroeder gives most space to his investment in Salomon Brothers. She allocates a hefty chunk of the book to that story, emphasizing his historic decision, in 1991, to become CEO and steer the investment bank through the Treasury scandal. Without Buffett, Salomon would certainly have been indicted on criminal charges and gone bankrupt.
There’s plenty of intriguing material on Buffett’s business dealings in Snowball, but Schroeder also delves deeply into his personal relationships, especially his interesting dynamic with Susan Buffett. The couple separated but never divorced, even after Buffett began to live with Astrid Menks (they didn’t marry until after Susan Buffett’s death). All three remained close, and the first Mrs. Buffett continued to fulfill her wifely role for all public events, including the annual shareholders’ meeting.
There’s something inevitable about the course of this life as Schroeder unfolds it. Logically, inescapably, one career triumph succeeds another; Buffett’s millions accumulate exponentially, with mathematical inexorability. The story’s relentless forward march and the profusion of lavish detail make Snowball both a work of scholarly value and a highly entertaining offering.
Peter W. Brush Jr., CFA, FRM, CAIA, is an associate in the rates sales group at RBC.
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Managing Hedge Fund Managers: Quantitative and Qualitative Performance Measures
by Edward J. Stavetski. Wiley. 2009. 258 pages. $85.00.
Edward Stavetski’s Managing Hedge Fund Managers provides a thorough analysis of the factors to be considered when investing in hedge funds. The book is particularly relevant now, at a time when less capital (due to deleveraging and redemptions) is chasing more alpha (due to market dislocations), making the hedge fund space more attractive. It is all the more compelling in our post-Madoff environment, as due diligence gains new significance, and investors are forced to play detectives.
For any investment, Stavetski says, the first step is to write an investment policy statement identifying objectives and constraints: required rate of return, time horizon, liquidity, and the level of acceptable risk. After that, picking the right hedge fund to achieve those objectives is as much an art as it is a science. In his view, quantitative measures raise questions rather than provide answers. Qualitative judgments are paramount.
Performance is a key statistic when evaluating a hedge fund, though prior performance is not a guarantee of future results. Stavetski outlines best practices in analyzing performance, and reviews myriad statistics representing absolute, relative, and risk-adjusted performance. Some of his favorites include the Sortino ratio and the downside deviation used to calculate it, time-weighted and dollar-weighted returns, and peer group analyses.
His insistence on evaluating performance both on the long side and the short side is right on the money. Many managers fall into the trap of shorting a general market index to act as a hedge without searching for alpha on the short side. The short side should be an important alpha source, and Stavetski warns investors strongly against any firm that fails to take advantage of that.
Stavetski devotes an entire chapter to weighing the arguments and empirical evidence relating to small funds’ alleged ability to outperform large funds—a highly debatable subject. The core reasoning in favor of this thesis is that, in the process of deploying more capital, good ideas can be exhausted, since “alpha is finite.” The counter line of reasoning, which Stavetski does not fully cover, is that large funds realize economies of scale and yield benefits that positively impact their research and trading. Although his overview is not conclusive, it provides a glimpse of the fascinating trade-offs that occur as hedge funds accumulate assets.
His thorough examination of the different types of risk is particularly valuable. The adequacy (or lack thereof) of value at risk is explored in detail. Liquidity risk is explained along with its measurement, and its importance is stressed, for when liquidity dries up hedge funds can be forced into losses. Counterparty, model, and high-watermark risk are highlighted as well.
His insistence on evaluating performance both on the long side and the short side is right on the money. Many managers fall into the trap of shorting a general market index to act as a hedge without searching for alpha on the short side. The short side should be an important alpha source, and Stavetski warns investors strongly against any firm that fails to take advantage of that.
Stavetski sees intellectual talent and leadership as hedge funds’ most important assets. Portfolio managers’ biographies (and those of their teams) play a central role in firms’ marketing strategies. Pedigree and prior experience, however, should always be the starting point for further inquiry by investors. Has the portfolio manager been successful running money, or in a different capacity? Has she left behind a portfolio in questionable shape? Does he have serious social or legal violations, even nonfinancial violations, which suggest a tendency toward irresponsible behavior?
The talents of portfolio managers and analysts should make money for the investor; sound organization of the hedge fund should protect the investor from losing money. Prime brokers, administrators, auditors, and other third-party service providers, commonly listed on a fund’s marketing materials, should serve as leads to more questions. To drive home this point, Stavetski relates the story of a fund whose auditor was run by its CFO. This should have been an immediate warning sign, and, indeed, eventually the fund closed down amidst losses. Obtaining the names and contacts of service providers is where due diligence starts—not where it ends.
But all the caution in the world is no guarantee of a good hedge fund investment. Stavetski makes a compelling point of how several of the legendary blowups occurred despite stellar manager biographies or periods of superior performance. In each case, he recounts what the red flags were and how investors could have spotted them.
Stavetski’s scrutiny may be sharp and his perspective skeptical, but he emphasizes that, despite heightened media coverage of hedge fund demises, fewer hedge funds have imploded to date than the number of corporations that shut down annually, and strategically chosen hedge funds can provide superior risk-adjusted performance. Managing Hedge Fund Managers is a comprehensive guide to the process of selecting hedge fund managers, and it flings open doors into a traditionally secretive world.
Boriana Handjiyska, CFA, is an associate at Morgan Stanley, where she provides portfolio analytics services to hedge fund clients.
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Animal Spirits: How Human Psychology Drives the Economy,
and Why It Matters for Global Capitalism
by George A. Akerlof and Robert J. Shiller. Princeton University Press. 2009. 264 pages. $24.95.
In classic theory, homo economicus is a rational being who seeks to obtain the highest possible order for himself, who optimizes information, opportunities, and constraints. But George Akerlof and Robert Shiller believe no such creature exists. Rationality, they say, limits the dimensions of inquiry, and isn’t the only tool we have. They argue that noneconomic methods are needed to reveal how real estate and the stock market can come to describe roller coaster drops and loop-the-loops, and, for example, how index averages could be halved in little more than a year.
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In John Maynard Keynes’s 1936 work, The General Theory of Employment Interest and Money, the phrase “animal spirits” refers to voids in quantitative economics that rational methodology does not explain. Now Akerlof and Shiller expand the term with reference to several other theories. Thomas Gresham’s insight that “bad money drives out good money” is crucial to this book, but the authors build on their own previous work as well, particularly Akerlof’s 1970 paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (one of the most cited papers in economic theory, which helped him win a 2001 Nobel Prize in company with Joseph Stiglitz and Michael Spence), and Shiller’s various challenges to the efficient market model, issued most famously in his Irrational Exuberance (Princeton UP 2000), a New York Times best seller.
Animal Spirits identifies five elements that are key drivers of the economy and markets and that are essential to diagnosing problems and prescribing solutions: confidence, fairness, corruption, money illusion, and exaggeration. Of these, the authors’ discussion of the role played by confidence in breaking the financial side of serialization is particularly engrossing.
When people are confident, they buy, of course. And when they lack confidence, they sell. Confidence, say Akerlof and Shiller, has a multiplier effect on national income, like the Keynesian multipler effect, which is defined as “1 divided by (1 minus the marginal propensity to consume).” They believe that the failure of conventional economic theories to take account of lost trust and confidence, to provide for the role of corruption, and, in general, “to consider the most important dynamics underlying economic crises” goes a long way toward explaining how most investors failed to foresee the credit crisis.
Ideologists are likely to dismiss this volume. However, for other readers—whether their perspectives are quantitative or qualitative—Animal Spirits may fill a troubling gap in existing investigations of the causes of booms and busts.
Thomas H. Wilkins, CFA, is chief executive manager of Joseph Jekyll Advisors, LLC.
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Panic: The Story of Modern Financial Insanity
edited by Michael Lewis. W. W. Norton & Company. 2008. 352 pages. $27.95
Michael Lewis’s anthology Panic examines four events, linked but distinct, that span a period of just over twenty years: the 1987 crash, the Asian crisis, the dot-com bubble, and the subprime crisis. Lewis has collected book, newspaper, and magazine articles written before, during, and shortly after each crisis; the contemporaneity of the analyses with the events precludes any hindsight or backward thinking. Instead, Panic is comprised of unfiltered accounts, admissions of bewilderment, clumsy stabs at solutions, and some examples of far-sighted predictions.
Lewis calls the 1987 crash “a collapse brought about not by real or even perceived economic problems but by the new complexity of financial markets.” Selling beget more selling, and prices cascaded ever lower. Then, when the Asian crisis took hold, speculative actions began feeding on themselves again. As Rob Johnson notes in a 1999 Frontline interview, “most speculative crises are accelerated in time by speculators.” In both the dot-com and subprime bubbles, Lewis writes, “the same herd instinct that fueled the boom fuels the bust.” When the herd turns, things get ugly.
The book is suitable for a general audience, but those readers who are investors will be most concerned with understanding what caused the current crisis, how it could have been prevented, and, most importantly, what it means for the future of asset prices. Of the 55 articles Lewis selected, two address these questions directly.
There’s more than a family resemblance between the four events that Panic examines, though Lewis warns repeatedly against reducing the complex causes and effects that distinguish each separate crisis to simple common denominators. What does stand out, painfully, across the chapters, are missed opportunities. Over and over, those who clearly foresee the future are dismissed.
The first is by Robert Shiller, from the Washington Post. To determine the trigger for the 1987 disaster, Shiller turned to surveys performed at the time of the crash. When those analyses turned out to be inconclusive, Shiller realized that “in seeking to explain the Oct. 19 phenomenon we should focus less on a triggering event than on the mechanics of the vicious circle itself.” That argument for emotionally driven price collapses is still pertinent and still controversial (see Tom Wilkins’s review of Shiller and George Akerlof’s 2009 book on psychology and economics, above).
The second piece that will be key for practitioner readers is a December 14, 2007, New York Times story by Paul Krugman. Krugman addresses panic-driven markets and the role of regulators, emphasizing the difference between liquidity—which triggered the 1987, Asian, and dot-com crises—and solvency, the core of the subprime crisis. He warns investors to prepare for losses well into the future as markets clearly identify who is troubled by liquidity needs and who is insolvent. That article unerringly predicts the bankruptcies and nationalization that have swept our markets. Investors with a sense of history and with the ability to distinguish which market crises were liquidity driven could have prepared for the eventual rebound in asset prices. Those who saw the solvency problems stayed clear of the damage.
There’s more than a family resemblance between the four events that Panic examines, though Lewis warns repeatedly against reducing the complex causes and effects that distinguish each separate crisis to simple common denominators. What does stand out, painfully, across the chapters, are missed opportunities. Over and over, those who clearly foresee the future are dismissed. Speculators, on the other hand, are lauded while prices spiral upward; then, when the inevitable occurs, “reckless speculators … are … recast as the victims,” and politicians who were complicit or complacent express shock and call for new regulations that ultimately fail, according to a 1989 piece from the Economist, “because of turf wars in Washington.”
Lewis has assembled an absorbing collection, but Panic’s paramount value may be, ultimately, not so much in the content of the individual contributions as in the overarching proof it gives of our own culpability in the reiteration of these meltdowns—our sins of omission, as well as commission.
Sean Hannon, CFA, CFP, is the president of EPIC Advisors, LLC, and the publisher of the weekly newsletter EPIC Insights.
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Leveraged Finance: Concepts, Methods, and Trading
of High-Yield Bonds, Loans, and Derivatives
by Stephen J. Antczak, Douglas J. Lucas, and Frank J. Fabozzi. Wiley. 2009. 368 pages. $80.00.
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It is often the markets that are not widely publicized by the popular press or closely followed by analysts that present the most complex challenges and most attractive rewards. The authors of Leveraged Finance understand that, and have put together a comprehensive overview that will orient new investors and prompt industry veterans to reevaluate some fundamentals.
Stephen Antczak, a UBS executive director within fixed income research and current head of the company’s leveraged finance strategy group, joins here with Douglas Lucas, from Moody’s ratings research team, and Frank Fabozzi, a respected author on the financial markets. They walk through the basics, starting with high-yield bonds and loans, then venture into rockier territory—collateralized loan obligations and default correlation. And there’s extended discussion of the synthetic markets, which include instruments like credit default swaps.
The central principle of Leveraged Finance is the application of concepts to real-world trading. The entire latter half of the book is devoted to corporate credit analysis, demonstrating how to evaluate corporate issuers and take a risk position, something every investor should consider prior to any investment decision. Investors involved in cross-asset and capital-structure strategies will be most interested in the arguments regarding compensation for a risk position. The detail the authors provide about subordination and hedging strategies is remarkable. They take care to address the factors that can often be overlooked, particularly in the case of nontraditional investors.
The section on default correlation is also exemplary. Not only are the concepts explicated with meticulous clarity, but the authors’ insight into the drivers of correlation will be extremely valuable for investors who are looking to properly hedge their credit portfolios.
While much of the information contained in this book brings a fresh perspective to the underlying issues that are currently impacting the financial markets, Antczak, Lucas, and Fabozzi have created a resource that will be invaluable to traditional and nontraditional investors long after the market recovers.
Chris Hazelton is a director in the global credit strategy team at UBS Investment Bank.
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Pioneering Portfolio Management: An Unconventional Approach
to Institutional Investment, Fully Revised and Updated
by David F. Swensen. Free Press. 2009. 432 pages. $35.00.
To be sure, Yale CIO David Swensen believes most institutions and the vast majority of individuals lack the abilities and resources to pursue active portfolio management strategies. That caveat aside, however, his updated edition of Pioneering Portfolio Management provides a comprehensive view of Yale’s highly successful endowment fund, and is an essential tool for those seeking returns and diversification beyond traditional asset classes.
The revised edition contains substantive improvements, such as coverage of Treasury inflation-protected securities, timber, and oil and gas. There’s also a new fixed income appendix on investment-grade corporate bonds, high-yield bonds, asset-backed securities, and foreign bonds. And there’s a slew of additional real-world examples that illustrate, very effectively, the many challenges of portfolio management for investors of all types.
After articulating the unique needs and missions of university endowments, Swensen begins establishing a framework for portfolio construction. Typically, institutional portfolio management focuses on allocation as the main return generator, with security selection and market timing playing minor roles. Swensen disagrees, and he thoroughly examines the potential contribution to returns of each of those three factors.
Scrutinizing the performance of outside investment managers by asset class sheds light on where to employ resources in security selection. It turns out that in highly liquid traditional asset classes security selection makes little long-term difference, as most managers hug a benchmark. For example, a table comparing managerial performances reveals that the US fixed income asset class shows a miniscule 0.5% difference over 10 years in the first and third performance quartiles. Low-cost index funds, which are easy to implement, serve the portfolio well. With more mispriced securities in illiquid alternative asset classes, a manager’s ability to actively select securities for superior returns is widely dispersed, as evidenced by the 43.2% difference in returns between the first and third quartiles of venture capital managers.
Swensen warns value-oriented investors against naïvely buying low multiple stocks on either a price-to-earnings or price-to-book basis. That tactic has delivered high returns, but at higher levels of risk.
Swensen opposes timing markets to generate returns because he wants to avoid moving away from agreed-upon policy portfolio allocations. That’s why the Yale endowment adheres strictly to allocation targets through daily rebalancing. Risk management is really the overriding concern of this contrarian strategy, although selling into strength and buying weakness does yield a small rebalancing bonus over time. Still, putting the portfolio on automatic pilot in this way can test commitment. It is revealing that, during the 1987 crash, even Yale needed additional meetings with the endowment investment committee.
The discipline of rebalancing prevents both active and passive investors from chasing winners, a dangerous behavior to which even institutional investors are prey. Swensen calculates a gap of 4.8% per year between time-weighted returns, which are divorced from the flow of investments in and out of a fund, and the dollar-weighted returns experienced by investors in aggregate in an institutional international value fund run by a highly regarded manager.
He warns value-oriented investors against naïvely buying low multiple stocks on either a price-to-earnings or price-to-book basis. That tactic has delivered high returns, but at higher levels of risk. A better approach to secure returns, in his view, lies in evaluating the quality of business management and future earnings prospects.
Potential allocations are examined through the prism of diverse asset pricing models. The inherent problems of mean variance analysis mean that optimization can only be a starting point in determining a portfolio with risk–return efficiency. In a neat extension of model inputs, Yale’s investment office simulates portfolio outcomes in order to explore the trade-off between providing stable funding and preserving principal over time.
Many will take issue with Swensen’s belief that most investors should steer clear of active investments. Even those at odds with his philosophy, though, should familiarize themselves with this book. His examination of the alignment of interests between investor and issuer, of inflation sensitivity, and of the market characteristics of each asset class provides a keen and useful perspective.
Paul Tanner, CFA, is principal of Granite Hill Capital Management, LLC, in Ridgefield, Connecticut.
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