Opinion

Triple whammy

Finance | 1 May 2007

Avinash Persaud suggest three big things investors
should think more about.

Investors spend too much time considering whether interest rates will rise. The return opportunities available of getting this right are small and the odds of consistently beating the market are stacked against individual investors. Investors spend much less time considering long-term trends that are probably easier to predict and are likely to be critical to performance.

One concern is an unusually profitable, but increasingly fragile financial system. Regulators have misinterpreted the growth of leveraged funds and derivative instruments as an example of good risk management supporting financial stability. They are wrong. This is not because leveraged funds and derivative instruments are intrinsically toxic. The issue is never about instruments, however complicated and dressed up they may be, but only about investor behaviour. Their growth is symptomatic of a behaviour, inadvertently supported by regulatory pressures, where financial institutions are rewarded for trading risk rather than absorbing it, a distinction that most regulators do not make.

The risk management strategy of most leveraged funds is that they will get out before others do. This is workable when times are quiet, the hunt is on for investing opportunities and there is a rich diversity of opinions about the value of investments. When investors get scared and everyone wants to exit markets at the same time, this strategy turns into a black hole through which many funds could disappear. This is when the system needs risk absorbers, like pension funds and insurance companies taking naturally long-term decisions and not being discouraged from doing so by short-term solvency and liquidity ratios. This is a systemic problem and there is not much an individual investor can do about it, but they can be aware of the impending crunch, keep their eyes open for it, consider financial insurance when it is cheap, and make sure that their fund managers have the capacity to hold the risks they are running.

Another concern is global demography. The domestic implications of ageing population is well researched. But the world is ageing at very different rates. Europe is ageing with worsening dependency ratios but parts of Asia, Africa and Latin America have improving dependency ratios. If local demography drives local savings and investment rates, global demography implies some very large international capital flows that will impact exchange rates, equity and bond prices. The size and direction of these flows will be counter-intuitive to investors focused narrowly on domestic considerations. Although demographic trends are slow moving, the greater certainty surrounding their direction warrants more attention than we traditionally give to other variables that are as unpredictable as they are impactful.

The final consideration is the international politics of climate change. We have the mechanisms and systems to reduce pollution and environmental degradation. Europe’s carbon trading system works moderately well as a mechanism but fails as politicians and voters have been playing at concern over the environment rather than acting, which entails a cost. Everyone is as united in its importance as they are that someone else is to blame for its degradation. One day we will be forced to take actions that impact behaviour. The consequences for investors will be enormous. Imagine a £50 daily congestion charge for getting in and out of London every day. If limits are based on trying to cap pollution at current levels, the biggest losers will be in the developing world where levels are low, but growing most rapidly.

If limits are based on population or geography, the biggest losers will be the industrialised countries that account for almost all of existing pollution. The nature of the global settlement will be highly political and have significant macro implications. But it will also have enormous micro ones. Forget bio-tech for a moment, the real winners in this brave new world will be pioneers in emerging environ-tech industries. Because these have so far been supported by subsidies in Western Europe, where voters are most concerned about the environment, the region hosts a disproportionate number. This may help Europe to become the Silicon Valley of the next sunrise industries.

Avinash Persaud is a financier and academic
 

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