The Finance Professionals' Post

The Great Mismatch: Addressing Barriers to Global Capital Flows (Part V)

PART V: Ideas for Navigating Capital Flows 

To succeed in the evolving global capital landscape, long-term institutional investors will need to be at the forefront of re-thinking long-standing assumptions and re-shaping markets. Enough success factors have already been identified to serve as a rough guide for investors to navigate the growing opportunities in emerging markets, while mitigating risks, in both the near term and beyond. (See Exhibit below.)

The Great Mismatch: Addressing Barriers to Global Capital Flows (Part IV)

PART IV: The Barriers to Efficient Capital Flows (continued)

Efficient cross-border capital flows—allowing investors to search for reliable returns, and in the process, meet legitimate capital needs wherever they are—would be a more effective way to finance the global economy than today’s system. In theory, few dispute this. In practice, many barriers have been erected that hamper efficient flows. The deliberate or inadvertent barriers to efficient global capital flows have been erected by a unique combination of regulators, governments, historical conventions and path-dependencies, investor mindsets and capital-seekers themselves (see below exhibit).

The Great Mismatch: Addressing Barriers to Global Capital Flows (Part III)

PART III: The Barriers to Efficient Capital Flows (continued)

Efficient cross-border capital flows—allowing investors to search for reliable returns, and in the process, meet legitimate capital needs wherever they are—would be a more effective way to finance the global economy than today’s system. In theory, few dispute this. In practice, many barriers have been erected that hamper efficient flows. The deliberate or inadvertent barriers to efficient global capital flows have been erected by a unique combination of regulators, governments, historical conventions and path-dependencies, investor mindsets and capital-seekers themselves (see below exhibit).

THE GREAT MISMATCH PART II: The Barriers to Efficient Capital Flows

Efficient cross-border capital flows—allowing investors to search for reliable returns, and in the process, meet legitimate capital needs wherever they are—would be a more effective way to finance the global economy than today’s system. In theory, few dispute this. In practice, many barriers have been erected that hamper efficient flows. The deliberate or inadvertent barriers to efficient global capital flows have been erected by a unique combination of regulators, governments, historical conventions and path-dependencies, investor mindsets and capital-seekers themselves (see below exhibit).

The Great Mismatch: Addressing Barriers to Global Capital Flows

Executive Summary

Cross-border capital flows are at an inflection point. While in aggregate they
have not returned to pre-crisis high watermarks—primarily driven by a significant decline in bank lending—they are increasingly varied in their scope and direction. More countries around the world are seeking and providing capital across borders than ever before. And asset managers and asset owners—not just governments, corporations and banks—are becoming increasingly influential in determining the scale and stability of global capital flows.

Yet capital around the world is being deployed inefficiently—large pools are not getting the returns they should, even as many needs for investment, both public and private, go unmet. This “great mismatch” is driven by a confluence of governments focused on near-term electoral cycles and rent-seeking, emerging-market financial institutions lacking investment management expertise and depth, and investors prioritizing short-term gains over sustainable long-term investment priorities.

Correcting this mismatch represents one of the most significant opportunities for global growth over the next decade. Success will require both long-term institutional investors and policymakers re-thinking long-standing assumptions and re-shaping their role in global markets. This report provides the backdrop and lays the case for six key recommendations over both the nearer and longer term:

Decomposition of Total Volatility: How Important is Idiosyncratic Risk?

Introduction

In recent years there has been a lot of debate about volatility, and the components of volatility. A lot has been said about the risk-on, risk-off market with a focus on macro and factor risks. There are many dimensions to volatility, and this paper uses the methodology of Campbell et al. (2001) to break down the total volatility in US equities into the three components of Market, Industry and Firm (idiosyncratic risk), and analyzes the trends in their share over time. We look at the time period January 2005 through December 2014, incorporating the years prior to, during and post financial crisis, and use S&P 500 as a proxy for the US equities, with the Global Industry Classification Standard (GICs) sector classification. The main conclusion is that there is a strong payoff to stock selection even in the post-financial crisis era where market participants often think of risk only in terms of risk-on and risk-off. The share of idiosyncratic risk indicating benefits of stock selection decreased a lot during the crisis. It is now at the highest level since the start of the financial crisis, though still much lower than in the pre-crisis years.   

Active stock selection can make the greatest contribution when idiosyncratic risk becomes a bigger component of total volatility. Campbell et al. (2001) laid out some important reasons for decomposing aggregate volatility into its sub-components of market, industry and firm. Aggregate volatility, important in any theory of risk and return, is the volatility experienced by holders of aggregate index funds. But aggregate market return is only one component of an individual stock’s return, with industry-level and idiosyncratic firm-level shocks being two other important components. Some reasons to be interested in volatility of the sub-components include holding portfolios that may not be diversified enough, or arbitrageurs trading stock mispricings facing risks related to idiosyncratic volatility. The optimum number of portfolio holdings needed to make it well-diversified is itself a function of the level of idiosyncratic risk.

Office Politics Surviving and Thriving—If You’re Savvy

Being politically savvy is a vital competence for anyone working in an office/organizational environment, but it’s not taught often and, in many cases, understood. In fact, in my practice as a coach the term “office politics” has received a bad rap. (Words like “Machiavellian,” “manipulative,” and “conspiratorial” come to mind.) Tales of political sabotage, power plays, and turf wars are part of any organization’s history. Nonetheless, political competence is the one skill everyone wishes to have more of—but no one talks about it. When you ask people how they achieve results within their organizations, they cite market analysis,strategic planning, and brainstorming. They almost never mention politics.

–Jeffrey Cohen

Jeffrey Cohen's services as a career and executive coach are now available to NYSSA members. Click here for more information.

Continue reading "Office Politics Surviving and Thriving— If You’re Savvy" »

Beyond Firm-Level Sustainable Capitalism

Generation Investment Management’s recently released white paper calls for a “paradigm shift” to Sustainable Capitalism. It is an admirable and important contribution to the discussion about how to make individual firms more sustainable. Beyond this effort, we need the sustainable business community to join the ongoing systems level conversation about how to make the whole global economy truly sustainable, not merely less unsustainable. Without such a systemic shift, the sum of individual firm sustainability efforts will not translate into sustainable capitalism.

In the spirit of contemporary Chinese artist Ai Weiwei’s belief—quoted in Sustainable Capitalism—that “liberty is about the right to question everything,” we offer five questions as a beginning to this critical dialogue:

What's Really Going on with US-Listed Chinese Stocks?

In this report, we analyze the technical position of every US-listed Chinese stock with a market cap above $5 billion. Of these, nine are based in mainland China, three in Taiwan and two in Hong Kong. By far the best looking chart is China Petroleum and Chemical while PetroChina shares are stuck at resistance. The worst stock, from a technical perspective is the telecom provider in Taiwan, Chunghwa Telecom.

From a value investing perspective, we believe that the best time to invest in a market sector is when sentiment is extremely biased against it. Presently, in our view, US-listed Chinese stocks appear to be one of the most reviled investment sectors, and not without some cause. A series of frauds uncovered by diligent short-sellers, and halfhearted support in reforming fraudulent practices by Chinese regulators have undermined confidence in Chinese stocks. The most widely cited index of US listed Chinese stocks, the USX China Index, is off 42% from its October 2007 high but has more than doubled from its November 2008 low.

We believe that Chinese stocks, having fallen out of favor, will gain newfound interest by investors. Later today, [Ed. Note: This paper is dated February 14, 2012.] Chinese Vice President Xi Jinping will be visiting the White House. Xi is expected to become the Premier or head of the government later this year and the media are expecting that this visit will lead to a “reset” of US-China relations. There are concerns about a slowdown in the Chinese economy as global commodities prices rise, real estate prices weaken and some manufacturing at the margin is returning to the US. But the Chinese economy is still largely tied to the financial health of its largest customer—the US consumer—who appears to regaining his health after a long illness. So despite the concerns, there is a bull case to be made for the Chinese economy as well.

---

---

We do not have a view as to whether Chinese stocks now represent a good fundamental value or how pervasive the fraud issues are. However, the key premise of technical analysis is that the charts represent “the wisdom of the crowds” or, in other words, the many market participants ranging from savvy short-sellers like Muddy Waters, large sell-side and buy-side firms globally, individual investors and corporate insiders collectively bring all their knowledge to bear in the setting of share prices, and those with the most conviction, and presumably best knowledge, have the most impact on price given the higher volumes they trade. So, stock prices tend to correctly reflect underlying fundamental value. So in this report we look at what the technicals are saying about US-listed Chinese stocks.

We begin with an overview of the major Chinese markets. Our focus is on mainland China, but it is impossible to analyze this market without considering the interrelated Hong Kong and Taiwan markets. The main stock exchange in China is the Shanghai Stock Exchange which trades two classes of stocks – A shares which are traded in Renimbi, and are limited to Chinese citizens and Qualified Foreign Institutional Investors, and B shares which are traded in dollars and available to global investors. The Shanghai Stock Exchange is 23% off its 52-week high and just 10% above its low having bottomed in January, so this may represent an interesting entry point for investors. In Hong Kong, the Hang Seng Index bottomed in September and has gained 29%. In Taiwan, the stock exchange is 19% off its high, having bottomed in December. The USX China Index of US-listed Chinese stocks also bottomed in October and is up 25% off its low. So investors are seeing something they like again in Chinese stocks. Overall, most stocks are at inflection points of breaking out to the upside. A positive catalyst such as a good visit by Xi or a Greek settlement could push these stocks significantly higher. But, in our view, it is definitely time to be looking east again.

–Barry M. Sine, CFA, CMT

This an exerpt from a white paper entitled, "What's Really Going on with US–Listed Chinese Stocks ?" by Barry Sine, CFA, CMT, Managing Director and Director of Research at Drexel-Hamilton. Click here to download the full report.

How Psychological Pitfalls Generated the Global Financial Crisis

ABSTRACT

The root cause of the financial crisis that erupted in 2008 is psychological. In the events which led up to the crisis, heuristics, biases, and framing effects strongly influenced the judgments and decisions of financial firms, rating agencies, elected officials, government regulators, and institutional investors. Examples involving UBS, Merrill Lynch, Citigroup, Standard & Poor’s, the SEC, and end investors illustrate this point. Among the many lessons to be learned from the crisis is the importance of focusing on the behavioral aspects of organizational process.

Acknowledgments: I thank Mark Lawrence for his insightful comments about UBS; Marc Heerkens from UBS; participants at seminars I gave at the University of Lugano and at the University of California, Los Angeles; and participants in the Executive Master of Science in Risk Management program at the Amsterdam Institute of Finance, a program cosponsored with New York University. I also express my appreciation to Rodney Sullivan and Larry Siegel for their comments on previous drafts.

Schrödinger’s Morning Paper: The Impact of Barron's on Stock Prices

Barron’s magazine hits newsstands on the first trading day of the week, and its cover story generally becomes an immediate topic of discussion in the business media, including CNBC, before the exchanges have even opened. Companies featured in Barron’s cover stories experience significant impacts on their stock returns and stock volumes during the first day of trading after publication. What’s more, the markets react to the stories as to brand-new information, and tend to trade on that information very quickly, especially in recent years.

Solutions for Hedge Fund Managers Considering the GIPS Standards

Although the GIPS standards do not address the particular challenges of hedge funds, claiming compliance is possible and increasingly important for hedge funds. Creation of a client presentation, the process and frequency of portfolio valuation, and net performance stream calculation methodology are some of the issues hedge funds tackle in claiming compliance.

Are All Components of ESG Scores Equally Important?

Our research questions whether all aspects of responsible investing are equally important for stock analysis. Can the different aspects of ESG performance—that is, performance in environmental and social sectors and corporate governance, as well as operations in “sin” areas—be combined for stock analysis? Our research is geared toward investment practitioners, and we therefore concentrate on stock returns (the main parameter affecting the performance of investment managers) and ROE (return on equity, which is arguably the most important parameter of corporate performance and stock quality). 

Sizing Up the Underwriters: A Five-Year Perspective on Underwriter Performance

Portfolio managers and other investors shopping in the high-yield new-issue market have long been in need of a practical tool to facilitate the process of evaluating and selecting securities. When assessing the attraction of new offerings, portfolio managers will consider such factors as credit quality, ratings, covenants, call features, and spread. For borderline cases, however, managers should take note of the underwriter’s record in structuring and pricing deals that hold up well in the aftermarket.

Whither Efficient Markets? Efficient Market Theory and Behavioral Finance

The notion of efficient markets has been the subject of rigorous academic research and intense debate for more than a century. As early as 1889, George Rutledge Gibson wrote in The Stock Exchanges of London, Paris, and New York that when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.” A reference to the concept of efficient markets is also found in French mathematician Louis Bachelier’s 1900 dissertation Théorie de la Spéculation. But it wasn’t until the mid 1960s, through the independent work of MIT economist Paul A. Samuelson and Eugene Fama, then a PhD candidate at the University of Chicago, that the efficient markets hypothesis (EMH) gained widespread acceptance.

Investing in Troubled Times

In these troubled times, with investors unsure of when or where to place their funds for maximum benefit, one investment tenet should be clear: bet on entrepreneurs. Our research of 27,000 publicly traded global companies, employing more than 12 years worth of data, demonstrates that entrepreneurial companies consistently outperform peer nonentrepreneurial companies by a wide margin. With very few exceptions these results remain true even after adjusting for year, market cap size, region, and sector. And, following the tumultuous market collapse in 2008–2009, it appears that entrepreneurial companies are now poised to perform better than ever.

Cluster Analysis as a Funds of Hedge Funds Portfolio Tool

Constructing a diversified portfolio of managers in a fund of funds requires a method for determining how the different exposures complement each other. We show how cluster analysis can be an important tool in this process, especially during a period of market turmoil. Cluster analysis complements the qualitative assessment of a manager’s style and can be used to develop a view of changing markets and manager responses to these changes.

Figure 1: Cluster Analysis Results

 

A Centralized Solution: Securitization, Rating Agencies, and the Path to Meaningful Reform

The financial crisis has brought to the fore, and indeed accentuated, the inadequacy of both regulatory bodies and our efforts to measure and mitigate risk throughout the financial system—particularly within the realm of structured finance, or securitization. While it is easy to criticize the performance of various market participants, it would be more productive to contemplate the underlying themes that emerged in the wake of this recent crisis. If we can accurately identify the root causes of the problems, we will be better positioned to resolve them.

Capture Ratio as a Tool to Measure Investment Performance

We examine the concepts of up-capture and down-capture, two widely used statistics for measuring investment performance. Our research indicates that each one on their own is an ineffective tool to accurately describe investment performance. However, the use of the Capture Ratio, the relationship between up-capture and down-capture, provides a much more useful tool.