The financial world has been suffering lately from Post-Greenspan Stress Disorder. The new chairman of the Federal Reserve, Ben Bernanke, has been accident-prone, and some investors have gotten the jitters. They might be reassured if they paid attention to the country’s second most powerful monetary official, New York Fed President Timothy Geithner.
Geithner watches for the scary meltdowns that could threaten the entire financial system. Like his mentor, former Treasury Secretary Robert Rubin, he’s a worrier – always looking for the “systemic risks,” the events that can trigger a panicky rush for the exits. He’s in a constant dialogue with the nation’s biggest banks and investment firms about how they manage risk.
As with globalization itself, the good news and the bad news in these markets are the same – greater interdependence. Financial markets appear to be better protected today thanks to products known as derivatives, that allow different kinds of financial risks to be shared around the world. You can hedge against almost anything these days, from hurricanes to interest rate hikes. The danger is that if this complex protective scaffolding ever failed, it could bring some of the global financial architecture down with it.
The last six weeks have been an interesting period for Geithner and his fellow central bankers. Some of the world’s smartest investors, who run the exotic portfolios known as “hedge funds,” got caught in a sudden downdraft in May. The investments that had proved most profitable – in emerging markets, commodities and other alternatives to large-cap stocks – all took nose dives. Investment strategies that supposedly were well hedged, so that losses in one sector would be offset by gains in another, turned out to be “correlated,” so that they all went down together.
The hedge fund industry prides itself on its “value at risk” models. But last month, traders say that some markets moved “six standard deviations” – in other words, six times the expected range of volatility. The fancy VAR models, based on past experience, failed to predict the actual damage.
The European Central Bank got so worried that it warned this month that hedge funds were the financial equivalent of bird flu and could pose a “major risk for financial stability.” And Raghuram Rajan, the chief economist of the International Monetary Fund, cautioned June 8 that hedge fund managers were all chasing the same investment magic they describe as “alpha.” This was making them all vulnerable to the same potential reversals.
The new alpha-mania may be the market’s latest folly. Ordinary investors make do with what’s known as the “beta,” which means basic market returns as embodied by the S&P 500 composite index of stocks.
But the pros want to emulate hedge fund managers in chasing the outsize “alpha” returns. Almost by definition, those will come from more exotic investments – from those tempting emerging markets in China and India, say, or commodities.
“Portable alpha” is the term investment managers have given to the notion that by moving out of the S&P 500 universe, they can match the performance of George Soros. It’s an investment version of Lake Wobegon, where all the children are above average. One factor pushing the market is the outsize reward for alpha performance. For the top 26 hedge fund managers, the average pay last year was a jaw-dropping $363 million, according to a survey by Alpha magazine.
Alas, the portfolio managers can’t all be above average. Indeed, as more and more asset managers began chasing the outsize returns, they bid up the prices of their pet alternative assets – to the peak levels from which they began to plummet last month. Since May 10, emerging markets have fallen by about 25 percent, for example.
Hedge funds have taken a smaller but real hit. In May, the Credit Suisse/Tremont Hedge Fund Index was down 1.3 percent, the first time since October it has posted a negative monthly return.
Geithner’s answer has been to stress the basics. In recent speeches, he has urged financial institutions to invest in better back-office infrastructure, so they know what’s on their books and can trade efficiently even during crises. And he urged senior managers to make sure they understand the real risk they’re carrying in their portfolios, by conducting tougher “what if” stress testing.
In the financial world, as in most things, people only learn by making mistakes. That’s why it’s useful to have little crises, like the one that swept through the hedge fund world in May. Lots of little crises reduce the risk of the big one.
David Ignatius (davidignatius @washpost.com) is the former editor of the International Herald Tribune.
