Dwight Cass
10/01/2005
One of the conundrums for Worth readers and the wealth managers who advise them is the enormous degree of financial risk they bear, often unbeknownst to them, due to their privileged access to alternative asset classes like hedge funds, private equity and structured products. These vehicles are some of the financial firmament’s brightest stars, but they are also among its most perilous.
Fortunately, alterative investments infrequently go supernova, and
then usually during times of severe market stress. It has been eight years since
the last serious global financial shock—the Asian/Russian/Long-Term Capital
Management crisis, which shuttered scores of hedge funds, for example. Since
then, the pace of financial innovation has accelerated. Indeed, the market for
principal-protected bespoke structured products for private investors barely
existed when currency speculators forced Thailand to float the baht in mid-1997.
Now it is a market worth hundreds of billions of dollars. Do you like biotech
stocks? Today, you can pick a basket of 15 that will pay you 75 percent of the
upside of the best-performing five after three years. Think the economy is
heading for a fall? Buy a basket of credit default swaps. Worried about interest
rates? Someone can be found to sell you a boatload of swaptions.But who actually understands any of this stuff? When it comes to their behavior in times of financial crisis, no one does, really. That is the message that underpins a recent, extremely thorough and occasionally alarming report from the unfortunately named Counterparty Risk Management Group II, a collection of senior risk managers and other officials from Goldman Sachs, JPMorgan Chase, Citigroup and many of the other institutions that devise and sell complex investment products to professional and private investors. (The report is available on the Web: www.crmpolicygroup.org.)
Fewer Potholes, More Crevasses
Its authors say that innovations in risk
management, along with more transparency and better regulation, have made the
financial system undoubtedly more stable today than it was eight years ago, as
witnessed by the minimal impact on the industry itself of events like 9/11, the
tech stock collapse and the spike in the price of oil, any of which could have
prompted a global financial crisis if it had occurred in previous decades.
However, the authors of the report add that the difficulty pricing many new
financial products, their illiquidity and the fact that adequate analytical risk
management technology is beyond the means of many smaller institutions raise
serious concerns about how the world of alternative investments will behave
under severe stress.
Hedge funds and private equity, although ostensibly
easier to grasp than structured products, are also fairly difficult beasts to
tame. As John Ferry notes in “The Holistic Approach” (page 92), no one has
developed the gold standard model for analyzing these illiquid assets in the
context of how they change the behavior of a private investor’s entire
portfolio. And, as with all things in wealth management, this context is the
key. Becoming a limited partner in a high-return private equity fund may sound
like a good idea when considered in a vacuum, but not if it raises your
portfolio-wide risk well above your pain threshold. While some firms are
devising useful ways to capture and analyze these idiosyncratic assets in a
broader context, much work remains to be done.
By whom? Well, those of us who
lack expertise in portfolio construction and other financial esoterica must rely
on our financial advisors. Even those private investors who cleave to plain
vanilla stock, bond and cash investments are exposed to how the broader changes
in financial technologies affect those instruments and markets; an exceptional
financial advisor will be able to steer that type of portfolio clear of hidden
shoals. For those with higher risk tolerances, a competent financial advisor
will find the safest ledge on which to perch. As a service to our readers, Worth
is pleased to recommend the 100 financial advisors listed beginning on page 75
as truly superlative in these matters.
Dwight Cass
Editor-in-Chief