In his latest "Outside the Box" newsletter, John Mauldin thanks Kathryn Welling, partner of Welling@Weeden for this week's installment: 'Capital Ideas' or CRAP? — an interview by Welling with Peter Bernstein and James Montier. In the interview, Bernstein takes on criticism of the CAPM [Capital Asset Pricing Model], particularly from Montier (See Montier's earlier article). In the process all three provide good insights and information.
Skipping toward the end of the interview, we gain a glimpse of a convergence of opinion among the three relative to hedge funds, herding behavior, and risk concentration:
[Kathryn Welling]: Hedge fund managers are theoretically unconstrained but in reality they're just as much a part of the herd as everyone else.
James [Montier]: Yes.
Peter [Bernstein]: Yes. Clearly, this was not the vision when it began and I have not had the chance to go back to [David Swensen, Yale] and ask him how he feels about the little monster that he's created. He was a pioneer when he said that the only way to have a successful institutional portfolio is to make uninstitutional decisions. But those uninstitutional decisions have now become institutionalized, yes.
[Kate:] One of the scourges of modern life is that the crowd very quickly catches up with innovators. In fact, I'm wondering if the ubiquity of the computer isn't more responsible than "capital ideas" for the changes we've been talking about in finance, Peter.
Peter: I think they go together. The computer is—I can't find the word. The magnitude of its influence is pretty obvious. The computer has provided the means for implementing some of these "capital ideas" in ways that you couldn't have imagined with a slide rule. The real thing about computers is the speed at which they work and the volume of information that they can process. …
[Kate:] But haven't computers allowed a lot of models to be implemented, in size, without…necessarily…a whole lot of thought? (Something that we humans tend to be all-too-happy to do without.)
Peter: They screwed up pretty good before the computer too— Yes, but everything happened much more slowly. And had many fewer zeros attached. … After all, 1929 and 1962 and 1974 were all events that took place before the computer. The computer just adds different ways of doing it.
[Kate:] But those train wrecks happened in relatively slow motion. Even crises like Penn Central and Drysdale Government Securities that I recall from early in my career unfolded at a pace I'm sure my kids would consider antediluvian.
Peter: Well, there's an even bigger difference. In every one of those financial crises, some big financial institution went bust, or New York City nearly went bust. There were major bankruptcy problems in every one of them. I'm not sure that I'm secure about this as a prediction, but just consider that the crash in 2001 was a big shock. The market decline started from a very high level. God knows, there had been a lot of crazy speculation—and yet no financial institutions blew up. The only companies that blew were things like Enron, where they were doing crappy accounting, and those failures didn't matter. They were independent events. That's pretty amazing. I don't know whether it's going to be that way the next time. But when you think about the magnitude, the suddenness, of that crash and the number of people who were involved in the market in some way, and that no institution blew—well that took me by surprise. I was waiting for it any minute. It's very interesting.
[Kate:] That surprised me, too. But I'm still not certain that some sort of systemic crisis or washout hasn't merely been postponed.
Peter: I'm not nearly as secure about the next one, whenever it comes, because the derivatives business has gotten so much more complex and involved and financial institutions—I'm talking about the banks, who used to be in the business of collecting deposits and lending money—are now deep into derivatives and the whole mortgage business is a derivatives business. How that will hold up when the heat gets into the boiler next time, I'm not nearly as confident. To say nothing of the world's currencies and what goes on there. …
[Kate:] So at the same time that you're celebrating the whole financial construct built on "capital ideas," you're standing back and saying, "But don't trust it."
Peter: I don't see any contradiction there. I mean, the markets can go crazy. Nobody can deny that. But what I'm saying is that the way we think about investments and the way we lead up to our decisions and the kinds of judgments that we make are the not the same as they were before all these ideas came to the fore. What I call "capital ideas" have opened insights and opportunities to people that they probably would not have seen before. God knows, the options pricing model, which was the last of these ideas to be developed and grew out of all of the others, has changed the world. In many ways, it has done so for the better because it has opened so many different kinds of opportunities for risk management. But it also has, like everything in life, the seeds of its own destruction within it. Somebody has referred to the option-pricing model as a bombshell and that really describes it.
James: The problem with bombshells is that they tend to explode.
Peter: But I don't see how that dilutes my theme. The theme is not that everything is going to be benign and wonderful because of Harry Markowitz and his followers, but that the ideas they promulgated have changed the way that people invest in a very profound way. "Capital ideas" have, in many ways, exposed opportunities and means of dealing with risk that people didn't think about before. They've made risk a central part of the investment equation. For sophisticated investors, risk is the beginning and the end of every investment decision.
[Kate:] But there's the rub, Peter. If we're using a definition of risk that elegantly fits mathematical models but doesn't begin to capture true investment risk, what does that say about the investment processes and all of the convoluted financial structures built on top of it? … Doesn't it come down to this: The super investors you're writing about are people who've been able to take your "capital ideas" and profitably turn them on their heads, in one way or another, before anyone else?
Peter: Yes, yes.
[Kate:] While the great unwashed, all the portfolio managers who dutifully apply the calculations they learned in school, produce at best mediocre returns?
Peter: Yes.
James: That's something that we're all agreed on.
[Kate:] It's not a particularly grand insight…
Peter: But there's a bigger insight than the one you just expressed. Portfolio theory says that the market is the dominant influence on returns. So those people may screw up and may not beat the market, or maybe they get lucky and beat it, but ultimately the market is going to determine how they come out. The market is the dominant influence. It's a simple idea but a very, very important one. …
Yet for all the talk about ever-more-free markets, and the reluctance to regulate them, we still have central bankers trying to smooth things over, while institutions deemed by many as "too-big-to-fail (to be be allowed to fail) continue to seek ever-more-heroic gains. There is something akin to
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