Look At Liabilities To Understand Assets

There’s a puzzle of sorts in asset allocation, and it falls under the rubric of uncorrelated returns.  When a new asset class arrives, and it is small and few invest in it — lo, it is uncorrelated!

But then the word spreads, and more investors begin investing in the alternative asset class.  This has two effects:

  1. It drives up the price of the alternative assets, temporarily boosting performance, and
  2. It makes the asset class returns more sensitive to the actions of large institutional investors, such that the correlations rise with stocks and other risk assets.

How an asset is funded matters a great deal as to future price performance.  I often talk about strong hands and weak hands in investing, but I can make it simple:

  • Strong Hands — Well capitalized, little debt, and what debt there is, is long-dated.  Such people can buy assets and ride out storms, not worrying about mark-to-market losses.
  • Weak Hands — Poorly capitalized, much debt, and what debt there is is short-dated.  A storm will capsize them, making them forced sellers of the assets they acquired with debt.

Buffett understands this.  His insurance companies have relatively low underwriting leverage, but they benefit from high allocations to stocks.  He can own stocks because there is a core amount of liabilities that will fund the stocks that he owns.

Think of housing for a moment. Asset prices were highest when the ability to use short-term low-cost financing was abundant. Eventually, there was no demand for housing when prices would lock in losses for buyers who would rent the property out.

If an asset is owned by entities that have weak financing, there is a real risk of loss if the financing can’t be maintained.  You become subject to the credit cycle, which governs much of investing.  Invest when credit spreads are wide; don’t invest when they are narrow.

I know that advice is vague, but that’s a part of the game.  You have to adjust the riskiness of your portfolio to overall conditions, and resist trends, if you want to make money over the long run.

How people and other entities fund the assets that they own has an effect on the future price performance, because it affects how they might buy or sell.

By David Merkel, CFA of alephblog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.