With bubbles starting to pop, the time has come to re-evaluate and re-engage with traditional ideas such as fundamentals and risk management, says Patrick Ghali, of Sussex Partners.
Investors, especially if they act as fiduciaries, should understand the inherent risk involved in investments they make. Simply looking at the ultimate return as the basis of whether an investment was good or bad shouldn’t be enough. Far from it.
Engaging in bets where the price for the potential upside is complete ruin should not even be a consideration. However, that is precisely what has been happening of late. Getting lucky should not be an investment strategy, though it seems that’s what a lot of investors have been waging on, and thanks to their success, may have come to believe that they were right in doing so.
Suspending disbelief and engaging in speculation in its purest forms has been most profitable. Embracing this strategy has certainly been extremely rewarding, and risk management and “common sense” have in many cases turned out to be a hindrance in the generation of outsized returns. Buying an asset in the hope that it could be flipped at a higher price in a short period of time, whether that was a crypto token, a NFT, a house or a meme stock was a quick and easy way to make money. Ignoring potential liquidity mismatches between assets and investment structures, and thereby collecting the “illiquidity premium” was another surefire way to generate returns and collect huge amounts of assets.
Focusing on fundamentals on the other hand almost guaranteed underperformance. The same could be said of risk management. As long as liquidity was ample, worrying about risk management only served to reduce returns.
Many investors have produced impressive track records through this unusual period. Often, the argument is made that being able to participate in such periods of “mania” is desirable, and it would be foolish not to partake. Surely missing out must be worse, perhaps even unforgiveable.
With bubbles starting to pop all around us perhaps the time has come to reevaluate and re-engage with traditional ideas such as fundamentals and risk management.
The final months of 2022 have given us: the implosion of FTX and with it a host of other crypto businesses which not long ago were lauded as the future of finance, and our society; the inability of one of the largest real estate funds to repay all its investors as requested (echoes of 2008?); significant down rounds in some of the best known fintech companies; and a sudden drop in house sales both in the US and Europe.
Analysing fund managers
These developments unfortunately, also extend when analysing fund managers, whether pursuing long-only or alternative strategies. There is no shortage of managers with puzzling pedigrees that have managed to set up in recent times, and that have produced stellar returns when market beta was cheap. Thanks to one or two good years, and some good stories, these “beta jockeys” have managed to reap huge fees, but now that the environment has changed, they are nursing huge losses.
In other cases, seemingly good returns mask serious underlying portfolio issues, where the rising tide has managed to gloss over massive failures of risk management and produce returns which on the surface still look compelling. It is only once these returns are scrutinised in greater detail that it becomes clear that all is not as it appears.
Is it ever a good idea, then, to invest in such a way? Should investors hold their noses and not care as long as the end result is a positive return, regardless of the inherent risk? Should investment be driven by process, or by exploiting loopholes and other people’s greed?
Madoff’s front running
There were plenty of investors that thought that Madoff was front running his clients and that were nevertheless happy to participate as all they were interested in was his seemingly never-ending streak of positive returns. Plenty of investors were, and still are today, happy to invest in strategies which employ some regulatory or tax arbitrage. Where does one draw the line?
The same holds true not just for fund managers but investments more broadly. In recent years, Investors had a choice of participating in initial coin offerings, yield farming and other crypto related “opportunities”, meme stocks, semi-liquid investments in private assets and a seemingly endless supply of private equity funds.
Many of these investments came with significant risks (some of which are yet to become obvious) but have generated outsized returns for a period of time. Some continue to perform (for now).
Bad timing and bad assets
While some investors managed to exit these investments profitably, others didn’t quite get the timing right. Were those that got out in time shrewd investors, or did they get lucky, and does it even matter? Is it a good strategy to invest in bad assets, questionable managers, strategies or vehicles with imbedded liquidity or leverage risk and take advantage of liquidity fueled bubbles, or is that just asking for trouble?
Do investors really understand the risk they are taking, are they taking these consciously, or are they being seduced by easy money and the promise of large returns or a lack of volatility (perhaps at the expense of gap risk and long-term illiquidity)?
One could argue that understanding how bubbles are fueled and participating in these is smart. Trading meme stock momentum, the hype around crypto and giving money to beta jockeys in such an environment can clearly be very profitable, but one is left with the uneasy feeling that for all the arguments put forward by those that profited from these trends, the reality probably is that an element of luck was involved.
Perhaps rolling the dice is the new investment strategy of choice.
*Patrick Ghali is managing partner of hedge fund advisory firm Sussex Partners.
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