Sunday, July 22, 2007

Stock Market Mood: Risk Seeking and Risk Averse Money Managers

The business of the professional money manager is to attract and retain capital. Performance is the most immediate means toward that end. The performance that matters to sophisticated holders of capital--from high net worth investors to large pension funds--is risk-adjusted return. Savvy investors want bang for their buck.

The trading and investing public hears about the big blowups, such as Amaranth, and thus assumes that professional money managers are highly speculative risk takers. Not so. Each well-run firm carefully monitors and manages its exposure to risk and its commitments to various markets. That monitoring filters down to the portfolio manager (PM) level, where PMs are regularly evaluated for risk-adjusted performance and either granted more capital to manage or not.

If a money management firm does not keep up with benchmarks, it cannot justify its fees and it cannot justify its allocation of capital from investors. Similarly, if a PM within a firm does not display solid risk-adjusted performance, he or she cannot justify an allocation of capital within the firm. Money is pulled from PMs that don't perform; they are "de-levered". Over time, their allocations can shrink to the point where they no longer represent a meaningful share of assets at the firm and can lose their position entirely.

For the firm, then, and for each PM, there is the Scylla of risk and the Charybdis of performance. The goal is to be sufficiently risk-seeking that you take advantage of opportunity and outperform benchmarks, but also sufficiently risk-averse that you avoid blowups. Moreover, firms and PMs have to keep up with competitors. You can't sit out a bull market; you can't be fully invested in a bear.

These realities mean that money managers tend to move as herds, oscillating between risk-seeking modes (and moods) and risk-averse ones. Consider late 2005 and early 2006. Markets were risk-seeking; the great performers were high-yield debt and emerging markets equity. From May through July, however, the mood turned decidedly risk-averse. Money flowed out of those popular markets and themes. The carry trade unwound. Emerging markets submerged.

If you're going to outperform the market on a relatively short time horizon, you have to think like the portfolio managers and money management firms that move the markets. You can't be putzing around with idiot wave patterns, numerological schemes, chart wiggles, or other foolishness that captivates the retail trading public. You have to look at the flows in and out of various assets and make a reasoned determination as to the moods of those large market players. Are they growing more risk-seeking, or are they growing more risk-averse? The answer to that question will tell you a great deal, not only about which markets are likely to move, but also how they're likely to move relative to one another.

So what do you look for in gauging market (and money manager) moods? Here are a few relevant to the current market:

1) Health of the Financial Sector - Many of the large PMs work at investment banks and hedge funds. Check out the stock performance of the publicly traded banks and funds. PMs know their own businesses. If they're not buying into their own sectors, that tells a story. (See the chart of hedge fund manager FIG above; see also the train wreck that is the BX IPO and the entire sector chart for $BKX). Right now, the large investors see more risk than reward in holding assets in their own, financial sector.

2) Performance of Treasury Instruments - When investors are frightened, they seek the safety of Treasury yields. That has the effect of pushing bond prices higher and yields lower. At the same time, they will shun higher-yield corporate bonds that are perceived as riskier. The net effect is to widen the yield spreads between the safest and riskiest fixed income sectors. On Friday, for example, Vanguard's High-Yield Corporate fund lost -.33%, while the Intermediate-Term Treasury fund gained .38%. No one wanted risk on Friday.

3) Performance of Equity Sectors - Risk-seeking equity investors will pursue beta. They'll gravitate toward small cap stocks within the U.S.; higher volatility international markets; and emerging markets. Risk-averse equity investors will stick with safe and secure large caps and shun more speculative sectors. Which sectors are leading the upside? Which the downside? On the surface, we've looked fairly risk-seeking, as the NASDAQ has been a strong performer. But a closer look finds that it's the large cap NAZ names doing the heavy lifting; more stocks on the exchange have been making new annual lows than highs. Keep an eye on China; among the BRICs, it's the poster child for risk-assumption and will be a leader in times of risk-aversion.

Moods come and go. We were risk-seeking in the late 1990s and tech was the primary vehicle by which this mood was expressed. Equities were in wide favor. When the mood shifted in 2000, large caps outperformed tech and smaller caps and equities went out of favor. We've been risk-seeking in loan practices (residential, private equity/corporate) until recently; now we're swinging toward risk aversion. Markets are interconnected; at times of great risk-assumption and aversion, correlations tend toward 1 and -1 across the board. Those are times of maximum inefficiency, when asset pricing will be most affected by greed and fear.

Moods--and especially large shifts in mood--create opportunity. But, like a great football quarterback, you have to see the entire field to capture that opportunity. There is far more to markets (and their movement) than the market you and I happen to be trading at the time.


What Makes a Professional Trader

Coaching the Professional Trader