Investment panels need contrarian thinkers

Article from The Edge Markets, some snippets:


The Ministry of Finance has tabled an amendment to the Retirement Fund Act 2007 that will see the removal of Bank Negara Malaysia (BNM)'s sole representative from the Investment Panel set up under the law.

A new section was also added to penalise any person who sits in any meeting of the fund’s Board, Investment Panel or any of its committees who discloses any information which is not published.


Malaysia is the country with the highest Power Distance Index in the world.

One of the many implications of that is that from time to time things seem to go well, and then "something" will blow up in a massive way. Toeing the line, not wanting to rock the boat are common treats in a country with a high PDI score. Because of that, scandals seem to be larger than in other countries, where they tend to bust more early.

To counter this, a few methods can be recommended:

• Lots of transparency, in the form of regular, detailed reporting
• Encouraging whistle-blowers to come forward and dealing with the information gathered in an appropriate way
• Encouraging contrarian minded people to participate in meetings to counter group thinking

BNM is the institution that I have the highest in Malaysia, they seem to be able to hold the line and stay (relatively) independent.

Because of this they could be an ideal partner in investment panels, to give their take on decisions.

The new amendment seems to counter this. The worry is that instead people are chosen who seem to be credible on paper, but who will simply toe the line.

Penalizing persons who disclose information might be a another step in the wrong direction, this time regarding transparency and whistle-blowers.

I am a big fan of the book "Antifragile" from Nassim Taleb, which deals with:

"an investigation of opacity, luck, uncertainty, probability, human error, risk, and decision-making in a world we don’t understand".

That looks highly relevant to the decision making process in Malaysia.

Alice Schroeder: "Many Black Swans Make the Metaphor Meaningless"

http://www.bloomberg.com/news/2011-10-23/many-black-swans-make-metaphor-meaningless-commentary-by-alice-schroeder.html

Nassim Taleb believes in probabilities, not predictions, but at times it can be hard to tell the difference. “The real Black Swan event,” he said in June, “is that people are not rioting against the banks in London and New York.”

Taleb saw it coming, and his well-publicized remark may be the only reason Occupy Wall Street hasn’t been labeled a black swan. This once-rare bird, made ubiquitous by Taleb’s best- selling 2007 book of the same title, now appears so often after dramatic events, such as Occupy Wall Street, that sightings of it have become meaningless.

The black swan was meant to be a rallying cry for preparedness. Instead it has become the opposite: a loathsome excuse for lack of planning by those who should know better. We need to send the swan to a rear shelf in the closet of ideas to gather dust until an actual black swan appears.

In the past two years, the term “black swan” has been applied to the earthquake in Haiti, the deadly Russian heat wave, the Gulf of Mexico oil spill, the stock market’s “flash crash” of 2010, the volcanic eruption in Iceland that spread an ash cloud over Europe, the Standard & Poor’s downgrade of the U.S.’s AAA credit rating, the populist uprising in Egypt, and lawlessness in Mexico.

Trivialized

The black swan has been so trivialized that it was even used to describe the 2010 “snowmaggedon” winter storms in Washington. And, of course, the black swan has been blamed over and over for laying the egg known as the financial crisis. Some observers are convinced that when they look at the sovereign debt crisis unfolding in Europe, they see ebony wings.

Taleb’s book regaled readers with stories of a space- shuttle explosion, the rise of Adolf Hitler, World War II, the emergence of Islamic fundamentalism, and the stock-market crash of 1987. Yet none of these events, nor recent crises, fits his definition of a black swan: the “unknown unknown,” an outlier with extreme impact for which nothing in the past “can convincingly point to its possibility.” In fact, if you waited long enough, the odds of such things happening approach 100 percent.

Taleb knows there are fewer black swans than people think. But he disdains experts, predictions and theories of causality. This makes his concept slippery: If nothing can legitimately be forecast, then anything is a black swan.

To his credit, in a revised edition of the book, Taleb freely admits he took the black-swan metaphor too far. A philosopher challenged his definition, to which he responded, “Indeed, she caught me red-handed. There is a contradiction: This book is a story.” He added, “Ideas come and go, stories stay.”

Taleb has been vocal in denouncing the idea of the financial crisis as a black swan. To cover such foreseeable extreme events like these, he created a category of “gray swans.” But gray swans are drab. Nobody talks about them.

The last event that I would call a true black swan was Sept. 11, when both World Trade Center buildings were attacked and collapsed, against engineering expectations. Contrary to many claims, the terrible 2011 Japanese earthquake wasn’t a black swan, even though seismological models, as they always do, failed to predict its severity. Apart from the huge loss of life, economic losses are estimated in the hundreds of billions, yet the insurance industry will probably pay out only about $35 billion in claims. Insurers are aware these events can exceed model predictions by wide margins so they have limited their earthquake exposure and excluded nuclear losses from coverage.

Gray Swans

Likewise, many of the other black-swan disasters of the past few years that are really gray swans have resulted in unpleasant, but far from crippling, losses for the insurance industry. And when the day comes that a gigantic asteroid strikes the Earth; a New Madrid-fault earthquake levels much of the eastern U.S.; or a bioterrorist/cyberspace attack hits, the insurance industry will already have arranged not to pay the losses through policy exclusions.

There is a disconnect here, and a big one. If insurers can spot the risk of a gray swan, underwrite and even exclude it, why aren’t those who are exposed to the risk doing a better job of preparing?

Instead we are making matters worse. For one thing, it was only a matter of time before Wall Street would figure out a way to profit from gray swans. As of April 2011, about $38 billion had been raised by “black swan” funds designed to profit from extreme low-probability events. Are these funds a canny strategy or a wasteful form of hedging? Either way, their proliferation certainly brings Armageddon closer by creating counterparties for the kind of risky optimistic bets needed to cause it. Many other responses to the so-called black swan of the financial crisis have added to the moral hazard already in the banking system.

The “too big to fail” taxpayer guarantee and the lack of substantive financial reform are the worst offenses. This isn’t what should be happening. If there had been no way to duck accountability by calling the crisis an “unforeseeable” event, the public might have demanded real solutions earlier from its leaders. Without the excuse of the black swan, perhaps there would be less reason now for anyone to Occupy Wall Street.

(Alice Schroeder, the author of “The Snowball: Warren Buffett and the Business of Life” and formerly a top-ranked insurance analyst on Wall Street, is a Bloomberg View columnist. The opinions expressed are her own.)

The Great Bank Robbery

http://www.project-syndicate.org/commentary/taleb1/English

By Nassim Nicholas Taleb and Mark Spitznagel

For the American economy – and for many other developed economies – the elephant in the room is the amount of money paid to bankers over the last five years. For banks that have filings with the US Securities and Exchange Commission, the sum stands at an astounding $2.2 trillion. Extrapolating over the coming decade, the numbers would approach $5 trillion, an amount vastly larger than what both President Barack Obama’s administration and his Republican opponents seem willing to cut from further government deficits.

That $5 trillion dollars is not money invested in building roads, schools, and other long-term projects, but is directly transferred from the American economy to the personal accounts of bank executives and employees. Such transfers represent as cunning a tax on everyone else as one can imagine. It feels quite iniquitous that bankers, having helped cause today’s financial and economic troubles, are the only class that is not suffering from them – and in many cases are actually benefiting.

Mainstream megabanks are puzzling in many respects. It is (now) no secret that they have operated so far as large sophisticated compensation schemes, masking probabilities of low-risk, high-impact “Black Swan” events and benefiting from the free backstop of implicit public guarantees. Excessive leverage, rather than skills, can be seen as the source of their resulting profits, which then flow disproportionately to employees, and of their sometimes-massive losses, which are borne by shareholders and taxpayers.

In other words, banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.

Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers – and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankers’ compensation last year was back at its pre-crisis level.

Of course, before being bailed out by governments, banks had never made any return in their history, assuming that their assets are properly marked to market. Nor should they produce any return in the long run, as their business model remains identical to what it was before, with only cosmetic modifications concerning trading risks.

So the facts are clear. But, as individual taxpayers, we are helpless, because we do not control outcomes, owing to the concerted efforts of lobbyists, or, worse, economic policymakers. Our subsidizing of bank managers and executives is completely involuntary.

But the puzzle represents an even bigger elephant. Why does any investment manager buy the stocks of banks that pay out very large portions of their earnings to their employees?
The promise of replicating past returns cannot be the reason, given the inadequacy of those returns. In fact, filtering out stocks in accordance with payouts would have lowered the draw-downs on investment in the financial sector by well over half over the past 20 years, with no loss in returns.

Why do portfolio and pension-fund managers hope to receive impunity from their investors? Isn’t it obvious to investors that they are voluntarily transferring their clients’ funds to the pockets of bankers? Aren’t fund managers violating both fiduciary responsibilities and moral rules? Are they missing the only opportunity we have to discipline the banks and force them to compete for responsible risk-taking?

It is hard to understand why the market mechanism does not eliminate such questions. A well-functioning market would produce outcomes that favor banks with the right exposures, the right compensation schemes, the right risk-sharing, and therefore the right corporate governance.

One may wonder: If investment managers and their clients don’t receive high returns on bank stocks, as they would if they were profiting from bankers’ externalization of risk onto taxpayers, why do they hold them at all?  The answer is the so-called “beta”: banks represent a large share of the S&P 500, and managers need to be invested in them.

We don’t believe that regulation is a panacea for this state of affairs. The largest, most sophisticated banks have become expert at remaining one step ahead of regulators – constantly creating complex financial products and derivatives that skirt the letter of  the rules. In these circumstances, more complicated regulations merely mean more billable hours for lawyers, more income for regulators switching sides, and more profits for derivatives traders.

Investment managers have a moral and professional responsibility to play their role in bringing some discipline into the banking system. Their first step should be to separate banks according to their compensation criteria.
Investors have used ethical grounds in the past – excluding, say, tobacco companies or corporations abetting apartheid in South Africa – and have been successful in generating pressure on the underlying stocks. Investing in banks constitutes a double breach – ethical and professional. Investors, and the rest of us, would be much better off if these funds flowed to more productive companies, perhaps with an amount equivalent to what would be transferred to bankers’ bonuses redirected to well-managed charities.