The Capital Inquiry

The Bad Economics of Protectionism

2008-06-26T06:47:00.000-07:00

In recent years, we have seen what appears to be a rise in governments adopting a protectionist stance to foreign acquisitions. Here for example is a selection of deals that have recently been blocked by host governments.

- New Zealand blocks a Canadian pension fund's proposed 40% stake in Auckland airport
- Dubai investors pull out from acquiring the same airport due to the controversy their proposed action causes
- The Japanese government blocks The Children's Investment Trust of the UK from taking a stake in the retailer J-Power
- Canada blocks Alliant Techsystems - a US company - from buying the space division of MacDonald Dettwiler
- US energy company UNOCAL rejects a bid from China's CNOOC due to concerns about political resistance to the deal

The FT pointed out in an article yesterday that in the past two years, 11 big countries which together received more than 40% of world inflows of FDI in 2006, have approved or are considering rules to expand government scrutiny of FDI, with the result of restricting it if such a restriction proves necessary.

The interesting questions for us are why this, and why now?

As I pointed out in another post here, emerging countries are becoming more active as foreign investors. High energy prices and high economic growth are enabling regions like China, India, Dubai and Qatar to become serious players in the acquisition game. Unfortunately, this makes politicians in target countries uncomfortable because - as they claim - the target companies are subject to national defence interest. While it is true that some of the proposed investments have been in sensitive areas such as ports, airports, energy and space technology, it is difficult to see how others in sectors such as gambling are subject to the same concerns.

I would contend that this rise in protectionism will hurt target and source countries alike. Contrary to what Naomi Klein would argue, companies that are acquired or established by foreign multinationals show faster growth in jobs, wages, investment and productivity. And lest we forget, countries that invest abroad tend to bring significant fruits of that investment back to their home countries.

Prospects Down, Sentiment Up or Why The Markets Are Crazy

2008-05-13T02:26:00.000-07:00

It has been interesting to note that the markets have had a positive reaction to the first quarter earnings season. Interesting because the picture that is emerging is not particularly good. According to Thomson Reuters for example, S&P 500 profits are on course to fall by 17.4% compared with a year ago. Bear in mind that the market's consensus was that profits would rise by more than 5%.

So why the decline? Well, the bulk of it has been due to the hammering the banking sector has taken in the wake of the credit crisis. In addition, there is a suggestion that commodity prices are squeezing profits for a large number of companies.

And yet, other companies are still talking up their positive prospects. The FT for example reports that Boeing expects heightened demand due to the need for more fuel efficient aircraft. Goldman Sachs has also suggested that "decoupling" is still in force by pointing out that in earnings calls, many company executives remain outspokenly positive about Latin America and China.

Predicition is a fool's game, and so for now we sit tight and keep an eye on things as they transpire.

Hedge Funds.What is all the fuss about?

2008-05-07T02:46:00.000-07:00

Hedge funds are an object of celebrity again. I say again because this is not the first time that they have been an object of celebrity. In the 1960s, hedge funds were quite fashionable largely due to the efforts of Alfred Winslow Jones who started the first hedge fund in 1949. The more things change...

My acquaintances and friends who have little experience in financial services always ask me to define this "hedge fund stuff" they keep hearing about. This is an excellent question.Not merely because a definitive answer eludes me, but also because many people with years of experience in financial services can't give you the definitive answer. Somehow, "I'll know it when I see it" doesn't quite suffice. So here's my attempt at unravelling this great mystery.

Hedge fund is a generic term that purports to cover a specific and specialised type of investment fund. The trouble is, these funds pursue different strategies from each other, they may invest in different asset classes to each other, and they ultimately meet with varying degrees of success. The devil it could be said, is in the definition.

Having said that, there are a number of elements of commonality that allow us to define these funds. First, hedge funds are unregulated. That is, where other investment funds may be regulated by the FSA or the SEC, hedge funds are unregulated and so do not have to meet minimum regulatory requirements in the way that other funds do. Second, hedge funds charge investors high fees. Typically, we are looking at a management fee of 2% of assets, and 20% of profits. Third, hedge funds allow short selling, which is the practice of selling shares that one does not own, on the assumption that they will drop in price. The whole process is explained here. Fourth, hedge funds employ leverage or borrowing in making their investments. This can greatly amplify their returns, but it can also lead to huge losses as Long Term Capital Management is famous for.

All of this is well and good, but the real question you have is whether investing in hedge funds will make you rich beyond even your wildest dreams. I'm afraid the answer is the same as that for all of life's most important questions. It depends. When you consider that there are over 8000 hedge fund managers, that their average shelf life is 2 and a half years, and that the great majorityof them will achieve average performance, it becomes clear that your only real chance of becoming rich beyond even your wildest dreams is to invest with that tiny minority of hedge fund managers who consistently outperform the average.

Sadly, these managers who perform the best become inaccessible except to those investors who have invested with them before. As I have stated above, hedge fund managers take a 20% performance fee and so do not feel the need to maximise the amount of assets under management. They therefore close their funds to new entrants.This means that the truly talented managers, those with an excellent track record, are unfortunately not available.

Perhaps you should start your own hedge fund. You now are an expert on the concept after all.

It ain't over until....

2008-05-01T05:06:00.000-07:00

I posted two days ago about the decline of the long-only mutual fund. Ye gads! We should know by now that an industry rarely goes away without a fight. It may lose, but it fights nonetheless. So today, we take out our looking glass and we study the response from the mutual fund players.

The crux of the issue is that fund firms will have to find new sources of revenue. Many have resorted to developing new products which have high margins and are therefore highly lucrative. Good examples of this are 130/30 funds which are modified long/short funds, as well as wrapping products with insurance policies.

Other funds have responded by introducing more performance fees rather than management fees. While others are expanding their hedge fund offerings. Pimco in particular is launching an “unconstrained” fund which will invest in fixed income securities without being tied to a particular asset class or strategy.

To me, it was ever thus. The strength and sustainability of our market economy has always relied on innovation. We make progress by adapting to change, and by unearthing new opportunities. We should count ourselves fortunate to be part of a system that rewards us for doing so.

The End of An Era?

2008-04-29T01:08:00.000-07:00

It appears that recent outflows from equity funds are accelerating. 24 out of the 25 largest US mutual fund managers have seen their long term assets fall in the first quarter due to falling returns and the fact that investors are simply pulling out their money.

This means that traditional money managers who have for the most part of the decade been experiencing double digit growth, are now struggling in actively managed mutual funds, and all this at a time when hedge fund managers and low margin indexed products are experiencing strong gains.

So what does this mean?

Well, in terms of broad impact, it suggests that the credit turmoil is hurting the confidence of mainstream investors. This could lead to a dampening of activity among consumers in the months to follow, since falling investment sentiment is often associated with a decline in household spending.

When we look at this activity more narrowly, and seek to understand its impact on the mutual fund industry, the prognosis for the patient is not good. Consider the fact that most of the outflow is money taken out of traditionally managed equities funds. Or that a recent study by McKinsey suggested that corporate pension plans would in the next five years invest half the total of the $2,300 billion they now have in equities, into different strategies. In addition, state pension funds are attempting to boost returns by allocating more of their holdings to private equity and assets such as commodities.

In short, it appears that long-only buy side firms are one day (maybe soon) to be no more. Indeed, Kevin Parker, president of Deutsche Bank’s $800 billion money management business recently told the FT,

“You can do nothing, which is a strategy. Milk the business for as long as it goes. But some day, maybe in my lifetime, the world will be split into passive investors, and into alternatives. What’s left in the middle is an endangered species.”

European Confidence Takes A Hit,

2008-04-25T01:35:00.000-07:00

In a further sign that world economic troubles are impacting growth, business confidence in Germany and France has ventured into negative territory. The Ifo institute says that the German business climate index fell from 104.8 in March to 102.4 this month. Its lowest level since January 2006. France's business sentiment index fell from 108 in March to 106 this month. Its lowest level since December 2006. To add to German woes, GDP forecasts suggest growth of 1.2% versus initial forecasts of 1.4%, and this is due to a stronger Euro, higher oil prices and a loming US recession.

As I am loathe to be a merchant of doom, I should point out that that the German survey was not all negative. Businesses indicate that they are still hiring, and there is a large backlog of orders from BRIC countries. Even so, investors yesterday took a negative view of prospects for future earnings, and this was reflected by what the FT termed an "equity market wobble" in early trading. However dear reader, my famous loathness (?!) to be a merchant of gloom spurs me on to observe that European markets nevertheless closed in positive territory.

The Credit Crunch and Emerging Markets. What next?

2008-04-22T08:27:00.000-07:00

As an inhabitant of this most esteemed planet that we call home, you are no doubt aware of the long drawn out phenomenon that is the credit crunch.
In what must be a relief to everyone - if indeed he is correct - Lloyd Blankfein of Goldman Sachs suggested last week that the credit crunch is on its last legs.
This was following actions from the Fed to restore confidence to the US financial system. We should also note that the Bank of England itself took steps to ease the effects of the credit crunch in the UK this week.

Anyway, of particular interest to me is what this means for emerging market economies which have been on a trajectory of four years of economic growth up to this point.

On the assumption that US interest rates remain low and a soft landing rather than an extended recession is the outlook for the US, I would venture that the outlook for emerging markets is positive.

Fundamentally, if the Fed's and the Bank of England's actions stimulate liquidity in the markets, I would venture that a significant amount of this liquidity would flow to the emerging markets as a higher growth
asset class.

Et Voila! And so continues the pursuit of health, wealth and happiness.