Will it ever be the same again?

As the financial storm has raged, the last two years have brought extensive debate about flaws in modern investment. What has received less attention, however, is that the crisis has also posed fundamental questions about 21st century investing and the nature of the industry which conducts that activity on behalf of hundreds of millions of citizens across the world. Investment managers are being forced to justify not only their asset allocations but the entire belief in the efficiency of markets, writes Jurie van der Merwe.

Unease is widespread about the very structure of the industry. While in much of the Western business world the trend has been to remove middlemen, investing has gone in the opposite direction.

Not only did the sector expand at a startling rate in the recent decades, but the ‘investment chain’ that links those supplying capital with the people who ultimately use it has become fiendishly complex, riddled with agents creaming off fees along the way.

Furthermore, financial advisers who are intended to recommend the best products for clients’ needs are often paid by the product providers. This creates an unhealthy focus among providers on designing products that sell rather than products that clients actually require.

During the crisis, it has been proved that financial markets are defined as much by participants as by their mechanics. “The car is important, but the driver is crucial – and a panic among the drivers makes the technology of roadways irrelevant.” (Don Putman, Grail Partners)

To some, the conclusion may seem self-evident. But to accept it, sweeps away assumptions that for half a century formed the foundations of the financial industry.

The reigning theory, often referred to in shorthand as “efficient markets”, is deeply embedded in the way that markets operate.

Investment advisers and financial planners run their businesses by comparing their performance against benchmarks – another idea from efficient markets.

If the theory needs to be abandoned, the effect on investing will be profound. More important still, is what will come to replace it.

Efficient markets borrowed from mathematics, but that is now widely regarded as an oversimplified and often downright misleading theory that fostered the cavalier confidence leading to the crash. Academics are now ransacking a range of other disciplines in the quest for a better understanding.

That search has ranged from evolutionary biology through to thermal dynamics and chaos theory. None is likely to deliver answers as clean and simple as those that came from efficient markets.

Modern portfolio theory

Modern portfolio theory, developed over the past 50 years in academia, has been based on the common premise that market prices at all times attempt rationally to incorporate all known information.

From this came the ideas that drove countless investment decisions: that the pattern of returns in financial markets follows the normal “bell curve” distribution often observed in natural sciences – that risk can be defined by the extent to which securities prices vary around their mean; and that observing how they have moved in relation to each other in the past allows a precise and measurable trade-off between risk and return.

Despite the weight that was put on the theory, it has long been known to have problems.

Firstly, market returns do not follow a bell curve. Instead, extreme events occur far more often than a ‘normal’ distribution would imply.

If stocks really followed a bell curve, then a swing of more than 7% in a day for the Dow Jones industrial average should occur once every 300 000 years. In fact, there were 48 such days during the 20th century.

Another obvious weakness in efficient markets is the assumption that investors always make their decisions rationally.

Virtually everyone knows this is not true.

Indeed, over the past two decades, a new discipline of behavioural economics has begun to substitute findings from psychology for the assumption of rationality.

But last year’s events inflicted fresh damage in the critical area of asset allocation – how to divide up an investment portfolio amount with broad asset classes such as shares, bonds and commodities.

Attempts are also under way to adapt the theory using “career risk”. This corrects for the behaviour of fund managers who are determined to avoid looking bad compared with their peers and will thus tend to move like a herd, into and out of the market.

As they are doing so to safeguard their jobs, which is a rational motive, this maintains the possibility that they are behaving rationally.

The problem after disproving well-established theories is finding an alternative theory. One theory borrows from Charles Darwin. Andrew Lo from MIT has produced arguably the best known idea – the adaptive market hypothesis – by borrowing from evolutionary biology.

His idea is that markets are “adaptive” and evolve over time. For long periods they will be stable – which explains how they will appear to be efficient for much of the time – but this will be punctuated by periods of crises when some species die out and others replace them.

While academics look for deeper models of markets that work, investment advisers and financial planners are left with a toolkit that suddenly does not work.

In the midst of the crisis, it was anticipated that the global financial system would be changed forever. There has been change, but not to the same scale that might have been expected.

It may seem that a drastic reshaping of the investment industry has been averted for now. If it has been averted, some permanent changes in the way fund managers invest, and in the way that investors ultimately behave, seem likely.

What has changed, however, is the way the industry offers funds to the public. While before there was an emphasis on “style discipline”, with funds that were closely tied to a benchmark and that promised to maintain a particular investing style – such as growth or value – now fund groups are offering “absolute return” funds. These are not benchmarked against an index, but instead attempt to make a strong return regardless of the market.

Certain principles will always apply. Attractive opportunities still await those who do careful research; capital structure still matters; and the best investor is a social scientist who analyses markets from both macro and micro views.

The macro view sees the 21st century defined by global competition for the world’s most valuable asset – human capital.

The challenge will be to foster these assets. Companies that foster them best will make the best investment opportunities.

Time for emerging markets

Every dark cloud has a silver lining. The dark cloud of the financial crisis will have a silver lining for South Africa. Developed markets have fallen out of favour. For many people, the future of investing can be summed up in two words: emerging markets.

This view has been strengthened by the experience of the past two years, when most of the financial problems surrounding subprime, toxic assets, stricken banks and overleverage were features of developed markets, rather than emerging ones.

Moreover, it has been an emerging market, China, that has led the world back from recession, rather that the United States – the world’s biggest economy that continues
to struggle.

This is a crisis that may prove the making of the emerging markets because during previous bouts of global financial turbulence, they have often been harder hit than their developed market counterparts.

This time, emerging markets rebounded more quickly, and emerging assets – particularly equities – have staged far stronger recoveries. This improvement has been so great that some commentators even believe that the term “emerging markets” is obsolete.

For instance, there is probably no doubt that Brazil’s macro-economic fundamentals and policy credibility are stronger than Italy’s, yet Brazil is an “emerging market” and Italy is considered developed. Brazil has a lower default risk than Italy, given the risk of a euro exit.

There have been major shifts in most elements that form the makeup of proper financial planning. The tools we use, the people we deal with, the economy we operate within and our clients’ expectations have changed.

But it is important and heartening to remember that any crisis delivers opportunities.

Those who adapt and act quickly are the people who will benefit most.