"I think the world is vastly more complicated today than it was in the past. You see in the past, say 50 years ago, or a 100 years ago... whenever they built the 'Mickey Mouse Economic Theories'; you would not think that going to the store to buy a shirt, would cause the cost of food to rise in the supermarket (you see?)... And the world is too complicated; you cannot forecast what is going on, because you cannot see the link between action and consequence very easily. So it is getting more complicated; the world is more interconnected... And again, you go buy anything made in China, you're causing the price of protein to go up (okay?): Who thought of that!?!"
—N. Nassim Taleb (Verbatim transcript of Taleb's opening remarks in his 14th August 2008 Bloomberg interview with Tom Keene)
In the post titled Regional Integration Increases Correlation of Regional Stock prices, I enunciated that the risk-management benefits of intra-regional diversification of a share portfolio, diminish as regional (political and economic) integration increases. In this post, I'll briefly explore the dynamics of securities' & market correlation. I'll start with a brief discussion of a factor that increases market interconnectedness: a capitalist explosion. I'll proceed by showing how exponential growth of hedge funds can be seen as evidence of a capitalist explosion. Then, I'll illustrate how crowding-out of investment opportunities, forces hedge funds to invest in other disparate markets: acting as a linking mechanism that connects different markets and securities (through portfolio positions). I'll conclude with a brief answer to the question 'What is increasing 'global inter- linkage'?
...Capitalist Explosion
******************************
...Capitalist Explosion
Nassim Taleb says that the 'world is more interconnected' than it was 50 years ago. Question: What is increasing this 'global inter- linkage'?
The causal factors of increased 'global interconnectedness' are multiple and often pervasive; it would be too cumbersome to identify, and list them exhaustively. However, I have noticed that global interconnectedness is intensified by propellants of asset price bubbles. Nonetheless, for the sake of brevity, I'll briefly expound on just one--which I believe is a key factor--of the augmentative factors of 'global interconnectedness'.
According to Robert Shiller's book titled Irrational Exuberance, the following factor, is a propellant of asset price bubbles (and according to me, this factor also increases the level of global interconnectedness):
Capitalist Explosion: Bloomberg.com defines hedge funds as 'private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested.' I like the Investorwords description of a hedge fund, which describes it as: 'A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%).' The key phrase in the latter definition is 'wealthy individuals and institutions'.
If the media's sociological projection of hedge-funds is anything to go by, then hedge funds are synonymous with capitalism. Therefore, one should be able to decipher the evolution pattern of capitalism (read as 'investment patterns of wealthy individuals') through a continual analysis of the hedge fund industry.
Between the first quarter of 2008 and the second quarter of 2008, (according to a Channel Capital Group report titled HFN Hedge Fund Industry Asset Flow/Performance Report, Second Quarter Ending June 30, 2008) the total assets managed by the hedge fund industry increased by 4.41% to a total of US$2.973 trillion! This compares to an increase of 9.82% in the second quarter 2007 and a decrease of 1.39% in the first quarter 2008. Evidently, the growth rate of hedge funds (in terms of AUM) is slowing, but it is not in negative territory as most would reasonably believe, i.e. the hedge fund industry isn't in a state of atrophy (in terms of AUM).
Interestingly, the hedge fund industry registered the AUM growth (through a combination performance gains and asset inflows) against the backdrop of; spectacular hedge fund implosions, weak global equities markets, bank failures, the drying-up of liquidity in most securities' markets, the exposure of deficiencies of risk-management systems employed by hedge funds, the development of multiple layers of correlation between 'disparate' markets and securities, deteriorating credit default quality, accelerated widening of spreads, the debacle of the mortgage-backed securities market and a global credit binge!
This is quite peculiar; I expected the hedge fund industry to contract (in terms of aggregate AUM) during this time period. The only plausible explanation I could muster for this strange phenomenon: high net worth investors STILL believe that the benefits of investing in hedge-funds outweigh risks associated with investing in these investment vehicles. Could this just be a prodrome of the 'untrammeled, morbid intensification of laissez faire capitalism', that George Soros wrote of in his essay titled The Capitalist Threat: a capitalist explosion? (Side-Note: Sounds like I'm about to blabber commie rhetoric, doesn't it? Read Soros's essay for illuminating insights on the 'flip side' of laissez faire market economics!). The notion of a currently-precipitating capitalist explosion ceases to seem mythical, and assumes greater plausibility when you consider that aggregate assets under the management of the hedge fund industry stood at US$875 billion in 2005 (according to Eric Falkenstein's 2005 article titled The Hedge Fund Advantage in Equity Management); and that now, the figure stands close to US$3 trillion (which translates to an aggregate growth rate of 243% over 3 years; or a growth rate of 81% per annum)! Therefore, we could be in the middle of a capitalist explosion, without even knowing it!
...Crowding out
Economic pundits from different walks of life, who are usually antagonistic, share a unified opinion on one thing; they all concur that the prospects for the global economy are bleak. Their forecasts of the foreseeable future of the global economy lie on a continuum that ranges from; "the global economy will experience positive, but lower-than-usual growth rates", to, "the global economy will sink into a deep, protracted, never-seen-before, 'black swan-esque' recession". As time passes, each analyst's forecast is progressively approaching a deleterious level of cynicism, and, empirical evidence is increasingly validating the conjectures of the analysts with extremist notions!
Given the current economic turmoil in global financial markets, and the heightened level of uncertainty that is concomitant to the economic pandemonium; it is reasonable for one to ask if exploitable, alpha-generating trading opportunities are still/will still be available in financial markets (?)
My answer to that will be: There are very few alpha-generating opportunities in most markets, and that opportunities will continue to dwindle (at accelerating rates) over time.
Here's why:
In Australia, The United Kingdom and The United States, financial market regulatory authorities have new weapons in their arsenals: short selling bans and their variants. Ostensibly, these legal tools are used to stabilize markets by protecting strategically important, but ailing companies from being 'short-sold' to death (remember what killed/massacred Bear Stearns?). Currently, there is on-going debate on the pros and cons of short selling bans; with the hedge-fund industry echoing more of the 'cons': Hedgies say that 'short selling bans rig the markets in favor of inefficient companies that should not be allowed to survive another day!', some even go as far as calling the bans 'weapons of mass market manipulation'. On the other side, is the Archbishop of Canterbury who has taken it upon himself to pontificate on the ills of short selling (side note: his 'short selling' sermons are heart wrenching). On who is right or wrong: time will tell. But, from my vantage point, it looks like other countries are going to be following suit SOON.
Short selling bans are, by definition, only enforced when the market is bearish. Hence, when regulatory authorities enforce them; hedge funds are prevented from short selling the stock of 'vulnerable' companies when it is most lucrative to do so. Therefore, this has the effect of contracting the alpha opportunity-sphere available to hedge funds; which (potentially) turns hedge funds into beta-generating asset pools with high fees (expensive hybrids of mutual funds). Furthermore, 'bans' (within an environment of; steady growth of the hedge fund industry's aggregate AUM, and a recession which limits the opportunity-set of 'long' trading opportunities), also increase the probability of 'crowding out' of limited lucrative trading opportunities. Hence, this causes the distribution of individual hedge fund alphas to shrink over time: a scenario that is consistent with the hedge fund capacity constraint hypothesis. Otherwise stated: the profitability of hedge funds might progressively deteriorate over time because of short selling bans. Zhaodong (Ken) Zhong wrote in detail about this in his research paper titled Why Does Hedge Fund Alpha Decrease over Time? Evidence from Individual Hedge Funds.
...Cross-Country Market Interconnectedness
The crowding of hedge fund strategies and positions; the progressive decline of aggregate hedge fund alpha over time; are in essence, push factors, that will force hedge funds to either, (1) close shop, or, (2) to search for opportunities in new territories - where strategies and trades are not crowded not.
In the latter scenario, funds will have to reinvent their strategies to allow them to invest in other markets and other geographical locations. This might entail transformation/evolution into a multi-strategy asset management company with a global macro component; a scenario that is analogous to Goldman Sachs' transformation from an investment bank, into a bank holding company (i.e. transformation into a more diversified entity that's perceived to be 'less risky').
When the 'diversified' asset management entity is set up, it takes positions in the new disparate markets, in addition to lucrative alpha-generating positions in markets it operated in previously. This has the effect of linking the 'new disparate markets' to the markets the asset management entity operated in previously: the markets become correlated, albeit subtly, through the asset management entity's portfolio. Any position-specific extreme event that wipes-out the value of the respective position, will have a negative impact on other seemingly disparate positions (in other markets) by stressing the portfolio. Hence, in an abstract sense, the asset management entity's portfolio is a shock transfer mechanism, that transmits shock from one market to other. Therefore, it is evident that global flows of capital are the linking-mechanisms of disparate markets.
So whats causing interconnectedness that Taleb spoke of? Answer: Diversified capital flows
