Increasing investment complexity alters strategy

April 4, 2010
| By Pete Daly |
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Mark Michon was talking a few months ago to a physician and his wife about the investment environment, when the doctor said he figured it was a good time to get back into the equity markets because of all the under-valued stocks to be had.

“His wife said, ‘No way! I’m not going to be getting up at 3 a.m. again, wondering if we’re going to have enough in our retirement fund so that we can eat,’” recalled Michon, executive vice president of the Investment Advisors division of Fifth Third Bank in Grand Rapids, which deals largely with high net-worth individuals.

The trend that came out of the smoking wreckage that was wealth management in 2008 and 2009 is “toward increased conservatism,” he said, and investors also tend to have a clearer understanding now of their risk tolerance.

“There is a new interest in products that are oriented toward helping manage that risk,” he said.

“We saw a flight toward quality” investments when stock prices were plunging, said Michon, which was reflected in that strange period when Treasuries dipped below par because investors were only interested in parking their cash where it was safe — never mind earning interest. Another investment seen as safe, and which thus enjoyed a surge in new activity, are bank accounts that are insured by the FDIC.

That conservatism and heightened awareness of risk is still going strong, but there is another trend in play: “increasing complexity for the investor,” according to Michon.

“There are a plethora of new structured products that are available that sometimes — not in all cases — fit the risk appetite of our clients,” said Michon.

Hedge funds, for example, are growing in interest among sophisticated investors “because of the explosive growth they’ve had,” said Michon, the bulk of which he described as “long-short hedge funds.” Investments might be long in companies with highly regarded management and short in those that lack those strengths.

There are some he described as “event-based hedge funds.” In the event of a merger, the fund might go long in the acquired company and short in the buyer, “because history shows there’s an arbitrage benefit to playing that spread,” he said.

Sridhar Sundaram, chair of the finance department within the GVSU Seidman College of Business, said that “clearly, there’s a lot of money” in hedge funds today. Hedge funds, he said, are really for the more qualified investors — “high-end investors” — who understand the risk involved and still are willing to participate, “and that’s one reason it is not a regulated industry like you would see in the mutual funds,” said Sundaram.

Minimum investment requirements generally start at $250,000 or $500,000, and the investor makes a commitment to leave his or her money in the fund for at least a year but often a minimum of two or three years, according to Sundaram. Hedge funds often tend to focus on esoteric strategies, such as Long-Term Capital Management, a hedge fund based in Greenwich, Conn., that borrowed billions of dollars to make big bets on the variation in interest rates around the world. It failed in 1999, threatening to ruin its lenders, and the U.S. government intervened for fear that its collapse would precipitate a full-scale market meltdown.

Sundaram mentioned a current star of the hedge fund industry who is the subject of a new book. He was referring to Michael Burry of Scion Capital in California; Sundaram described him as an individual who “bet against the real estate” bubble.

Burry’s investing career originally blossomed on a careful search for value stocks. Then, in 2005, he figured out that sub-prime mortgage-backed securities were a ticking time bomb, and he may have been the first to persuade major investment banks to let him buy credit default swaps on their pools of mortgages. In essence, he was buying insurance on securities he figured were heading for big trouble. Then others began buying the credit default swaps and the investment banks stopped issuing them.

Burry hung on, despite some angry investors in his fund, and when the collapse of the sub-prime mortgage-backed securities began in 2007, his bet paid $725 million for his clients and $100 million for him.

The growing complexity of investment possibilities today presents a challenge even to sophisticated investors, according to Michon.

“What we find a lot of times are people with good judgment skills who are making good decisions based on now incomplete or sometimes bad information,” said Michon. So now, he said, the responsibility of his division at Fifth Third “is to challenge those assumptions.”

Fifteen years ago, an investment portfolio may have been a mix of large cap stocks and bond portfolios. “Now we have 12, 13, 15 asset classes,” he said, and 84 stock markets around the world, each with large, mid and small cap stocks, alternative assets and fixed-income opportunities.

It used to be that part of a diversification strategy was a selection of large cap stocks from different countries, but now in the developing and growing economies around the world, with the globalized economy, “you can’t depend on that as much as a diversification deal as you did in the past,” he said.

“I think, as we move out of the last 24 months, as we look at the trend toward globalization, toward increasing complexity, toward greater understanding of our own risk tolerances, we’re starting to see people move away from the ideas around investing over the last 10 or 15 years,” said Michon.

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