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The layer above: the techies who really drive the markets

13 Dec 2013 90 month(s) ago

“nerd”When SMSF investors undertake investments in the Australian share market or other asset markets, they should be aware that they are operating at the traditional level. Above them, there is another level of computer driven geekery that is using what they do as data to feed into their risk models.

“nerd”DIY super investors, like most smaller players, tend to assess the investments they make in terms of what kind of business or asset it is, in isolation. Will the company make good profits? Is it undervalued? Is the property likely to get a capital gain? Does it have good rental income? Where will interest rates go on this term deposit? How will interest rates affect the price of bonds?

This is the traditional approach to investing, which has been the norm for centuries. But over the last two decades a new type of investing has emerged. Let's call it meta-investing. This is when technical whizzes apply another level of investment analysis above the the traditional approach to investing. They don't worry about the value of the assets themselves so much as look at the risk (and opportunity) that the prices of those assets will vary significantly.

This has transformed markets -- and made them much riskier places for investors. It has led to what are called derivatives, transactions that are "derived" from traditional investments such as equities, bonds, mortgages and cash. Derivatives trade has exploded and it is what nearly brought down the world's financial system in 2008. Daily derivatives trade is now over $US4 trillion. In five days, the markets transact more than the entire US debt of $US17 trillion (which puts the worry about US defaulting on its debt into a different perspective).

Because of what happened in 2008, the emphasis is now very much on managing risk. But this, too, is being done in an extraordinary high tech manner. There is little analysis of what the businesses and assets are actually worth and instead a focus on managing what might happen -- using computer models. When SMSF investors undertake investments in the Australian share market, they should be aware that they are operating at the traditional level. Above them, there is a whole other level of computer driven geekery that is using what they do as data to feed into their risk models.

The Economist has an article about the world's biggest investment manager Black Rock, which oversees a massive pool of assets:

"Its reach extends further: to corporate bonds, sovereign debt, commodities, hedge funds and beyond. It is easily the biggest investor in the world, with $4.1 trillion of directly controlled assets (almost as much as all private-equity and hedge funds put together) and another $11 trillion it oversees through its trading platform, Aladdin."

Black Rock has a lot of passive investments and it did well in 2008 because it analysed the riskiness of US mortgages zipcode by zipcode. It avoided a bail-out after Lehman collapsed, advised the American government and picked up profitable money-management units from struggling financial institutions in the aftermath of the crisis.

Now it is so big that it, or rather its risk management models, are driving the markets:

"In a data centre nestled between the orchards and hills, a cluster of 6,000 computers oversees the assets of over 170 pension funds, banks, endowments, insurance companies and others. Whirring around the clock, the machines look at what interest-rate changes, or bank collapses, or natural disasters could mean for trillions of dollars of assets. Around the world, 17,000 traders have the computers’ assessments of these risks at their fingertips when they buy or sell assets."

This computer driven analysis is as important a change to the financial markets as the governments' surveillance of digital communication is important to privacy (as has been revealed by Edward Snowden and others). SMSF investors should know that when they invest in public markets, there is often a layer above them of people investing massive amounts of money using computer models. In a sense, the small investor has been reduced to being a data input for much bigger players.

The core of Black Rock's influence is Aladdin, a risk management model. If SMSF investors want to know what really drives markets, this is a good place to start:

"Aladdin, like the little Sun machine next to the company’s original fridge, is there to help people who manage money understand what they own. An institution like CalPERS—which uses Aladdin to keep track of the $260 billion it has invested to pay for the pensions of Californian public employees—needs to understand when its bonds will come to maturity, or how its assets will move if interest rates fall, or what would happen if a counterparty went bust. Aladdin is the tool it uses for the job.

The system is based on a large and, its creators say, particularly well quality-controlled trove of historical data. On the basis of that information it uses “Monte Carlo” methods, which produce a large, randomly generated sample of the huge range of possible futures, to build up a statistical picture of what could happen to all sorts of stocks and bonds under a range of future conditions. These risk assessments cover both likely futures that matter day-to-day, and less probable but highly salient ones. A portfolio can, say, be stress-tested by being put through market turmoil modelled on that which followed Lehman Brothers’ collapse, to see what happens. Users can see their portfolio’s predicted response to a “tapering” of the Federal Reserve’s asset-buying programme or to the onset of a global flu pandemic.

The aim is not just to figure out how each stock, bond and derivative in a portfolio would move. It is also to check how correlated those movements are, and how that correlation could amplify a shock. For example: combining shares in an Indonesian bank, a bond issued by a European power company and a basket of mortgages secured on Canadian shopping malls might seem like a sensibly diversified portfolio. But some changes in credit availability might set them all tumbling. That is the sort of thing that Aladdin, having tracked such assets through previous crises, is meant to spot. Armed with insights from these simulations, traders managing large, complex portfolios can tweak their holdings accordingly."

If there is one thing that was learned in recent crises, it is that computer driven models that are designed to eliminate individual risk, create systemic risk which cannot be sensed by those same models. When Long Term Capital Management (LTCM) nearly brought down the world's financial system in 1998, the guilty parties were the world's experts on risk. Yet they did not see the risk that they themselves created. Ten years later, there were many LTCMs (the US regulators had recklessly allowed them to spring up) and an even worse crisis ensued.

Black Rock's risk analytics have the potential to create the same kind of problem. Not only are SMSF investments just reduced to being data inputs into the computer models, they are also imperilled by the computerisation of the markets:

"Privately, some market participants fret that BlackRock’s genie is creating a new orthodoxy when it comes to analysing assets. That is especially true for complex structures which require its forensic expertise to unpick. “Nobody understands some of this stuff” without going through BlackRock, says a portfolio manager who uses Aladdin and regularly trades with the firm. A potentially worrying development is that it is now possible to engineer bonds to maximise the chances of BlackRock investing in them.

The disturbing parallel is with credit-rating agencies such as Moody’s and Standard & Poor’s in the run-up to 2008. Investors blindly relied on the agencies’ analysis of financial constructs underpinned by subprime mortgages, many of which were engineered in such a way as to ensure AAA-rated status but subsequently defaulted anyway. BlackRock’s models are undoubtedly more sophisticated than the credit-rating agencies’, and their use is not mandated by regulators. But Mr Fink is the first to admit that they are flawed, too: “If you believe models are going to be right, you’re going to be wrong.
 
The question is whether BlackRock’s clients understand that they are not meant to rely on Aladdin’s prognostications for investing. BlackRock executives insist their models are designed to validate ideas that have been arrived at independently by clients rather than to generate them. That said, the company’s marketing materials talk of Aladdin’s services as a way to “see opportunities” in markets."
 

The truth is that the global investment markets are run by intermediaries and geeks, not people who have "skin in the game". That is an important lesson for SMSF investors. Their skin is in the game. But that is not the case for those who really drive the markets.