This time no contribution directly related to Emerging Markets, but a more general one illustrating what goes wrong when people without sufficient knowledge enter the investment arena.
Goldman Sachs, by far the most prestigious Western bank at the moment, is charged with fraud by the Securities and Exchange Commission. The Washington Post reports on the details of the case in a lengthy, excellent article. The case is illustrative of what was going on in Wes...tern financial markets - both at the private and institutional level - when the Global Credit Crisis happened.
At the heart of the fraud charges was Goldman's collateralized debt obligation (CDO) product Abacus. Abacus represented a basket of sub-prime mortgage securities that was sold long (i.e. with the basic assumption of buyers to gain from expected value appreciation) to outside investors. German bank IKB and Dutch ABN Amro were buyers according to the Washington Post article. And - maybe not surprisingly - both were bailed out by their respective governments in the crisis. Abacus was not the only thing that went wrong in these banks.
Goldman's Abacus Product: Did clients have a fair chance to make money with it?
And did Goldman fulfill its fiduciary duties?
INVESTORS WANT TO BE FOOLED
What was going wrong was that the culture amongst long investors was one in which they were buying products they didn't understand as long as the creator of the product was a 'fancy', blue chip name on Wall Street OR a good performing hedge fund with strong momentum, good publicity and crazy astronomical returns on earlier products or in earlier years. Hedge fund managers were seen as the new superstars because they created seemingly impossible results that were often more related to excess leverage than skill. But unfortunately market participants - like so often - didn't want to hear the warnings by independent, outside consultants. Actually: we saw the craze happening. Already back in 1999, at the beginning of the 'securitization' cult that created so many complex synthetic products LMG Emerge principal Erik van Dijk and Noble Prize Laureate Dr Harry Markowitz warned the audience in a seminar organized by Dutch business school Nyenrode University that 'securitization' would only work when a) the created basket was well-diversified; and b) sufficiently transparent for investors to understand what they were buying.
But during the first decade of the 21st century and the 1990s the buyside investment community fell for a new type of trap. Good consultants did and do always warn investors not to believe in miracles. Examples: don't believe that you can earn far more than 10-15 percent maximum on equity strategies or 5-10 percent on bonds in good years ON AVERAGE and be prepared for bad, negative years when investing in equities during the wrong period and flat, zero-return periods when opting for bonds and other fixed income products. Real estate? OK, there were countries that presented good returns like the Netherlands during a long period of time, but neighbor country Germany didn't do well in that asset class at all. Private equity: sure, good returns possible, but highly illiquid and that is also risk. The more investors learned about asset classes, the more they felt that success stories in other regions (Emerging and Frontier investing) or in different type of stocks (small or micro caps) could present the holy grail of risk-adjusted excess returns. At the same time we continued to believe in that one or two superb specialists that were really the ultimate Guru. Guys like Warren Buffett or Pimco's Bill Gross. Or maybe Bernard Madoff. But like so often - as always Guru's are human as well. And market's cannot be easily beaten other than maybe score a 3-5 percent excess return over longer periods of time. Nope, people wanted to believe far more than that was and is possible.
THE QUEST FOR NEW HOLY GRAIL PRODUCTS
With the rise of Emerging Markets and cheaper investment possibilities in small and mid-sized stocks during the first ten years of this century, growing numbers of investors learned that previously secretive, mysterious markets were not part of the holy grail they were looking for. But instead of accepting that there ain't such thing as a free lunch in the form of a holy grail with astronomical returns, they fell for the hedge fund trap: returns on highly levered portfolios, i.e. portfolios financed with exceptional levels of debt, look great when interest rates paid on the debt are low historically and even going down (what we saw happening during the last 10-20 years when markets moved into a demographic situation of structural change with populations getting older and with the negative correlation between interest rate levels and population age doing the rest). But: this free lunch only works when a) hedge fund managers are exceptional stock pickers and b) negative returns or even returns lower than the interest rate paid on the debt can be avoided. As always: this is possible as long as it is possible, and sooner or later even these superstars turn out to be superstars in making money only. Making money for themselves that is, and that is something else than making money for their clients. Sadly enough at the time of the crisis thousands of investors learned this the hard way.
But some hedge fund managers are better than others. Far better. Just like some basketball players are like Kobe Bryant and others like us: good-willing amateurs.
But in a market we cannot expect to always be on the side of the Bryant's and win time and again. Problem with markets is that by acting in the market, information is disseminated between investors. And the more successful an outperforming manager, the more known he gets and the quicker the dissemination of his information. Result: his outperformance potential drops when he gets more famous. In other words: good managers do have a maximum holding period. One manager that was making himself a name was John Paulson - no family of former Goldman CEO Hank Paulson, who later became US Treasure Secretary under George W Bush. John Paulson was one of the best so-called 'short selling' specialists.
One of the World's best short-sellers involved in the creation of a long product?