I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc. Here goes:
1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to. How much implicit equity exposure do we get from our variable annuities?” The idea was this: as the equity markets go up, so does our fee stream. If the equity market goes up or down 1%, how much does the present value of fees change? I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.
Welcome to our latest issue of issue of ValueWalk’s hedge fund update. Below subscribers can find an excerpt in text and the full issue in PDF format. Please send us your feedback! Featuring Andurand's oil trading profits surge, Bridgewater profits from credit, and Tiger Cub Hedge Fund shuts down. Q1 2022 hedge fund letters, conferences Read More
2) This post, Why are we the Lucky Ones? could have been a post in this series. At a small broker-dealer, all sorts of charlatans bring their ideas for financing. The correct answer is usually no, but that conflicts with hope. Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.
3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.
4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm. I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.
Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing. Go variable by variable, on a long term basis, and ask:
- At what level does this bring line profits to zero?
- At what level does this bring company profits to zero?
- At what level does this imperil the solvency of the company?
5) This story is a little weird. One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC. You are our representative. They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts. Your job is to make sure the fund is not created.”
His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs. He didn’t want to get stuck with losses. I told him the persuasion was not my forte, but I would do my best. I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table. Use it.”
A few days later, I was on the Metroliner down to DC. I tried to understand both sides of the argument. I even prayed about it. Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund? What might be the moral hazard implications?
At the meeting, I found one friend in the room from AIG. We had worked together, and American International Group Inc (NYSE:AIG) didn’t like the idea either. In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us. Not promising. We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.
By 3PM the moderator asked for any final comments before the vote. I raised my hand and said something like, “You have to think of the law of unintended consequences here. What will be the impact on competition here? What if one us, a large company decides to be more aggressive as a result of this? What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance? The state guaranty funds would certainly like the industry to put even more skin into the game.”
The room went silent for a few seconds, and the vote was taken.
4-9 against creating the guaranty fund.
The moderator looked shocked.
The meeting adjourned and I went home. The next day I told my boss we had won against hard odds. He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me. This is the thanks I get for trying something very hard?
6) In early 2000, I had an e-mail dialogue with Ken Fisher. I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value. Throw away the CFA syllabus, and all of the classics — look for what is not known.
So I sat down with my past trading and looked for what I did best. What I found was that I did best buying strong companies in damaged industries. That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.
My career has been odd and varied, which has led to some of the differential insights that I write about here. In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust? Not many, and even I did not anticipate the intensity of the bust. At least I didn’t own any banks, and only owned sound insurers.
Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc. We can create our own crises by moving together in packs, going from bust to boom and back again.
It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important. It is not what you earn, but what you keep that matters.
By David Merkel, CFA of alephblog