Practical analysis for investment professionals
21 December 2015

Best of 2015: A Sea in Agitation

Posted In: Best Of

As a high-ranking officer in the Union Army during the American Civil War, Lew Wallace must have experienced the sense of smallness felt by an individual person caught in the midst of a great conflict. Decades later, that experience found expression in his novel Ben-Hur: A Tale of the Christ. A theme of powerlessness runs through the dramatic story of betrayal, revenge, and redemption. As the novel unfolds, the sea comes to symbolize the vast impersonal forces — chaos, volatility, unpredictability, shifting currents of fortune — that seem to shape individual destinies.

In some ways, looking back over the articles published in CFA Institute Magazine during 2015, this literary theme seems fitting for investors and markets over the past year.

The novel’s protagonist, Judah Ben-Hur, owes his family fortune to an international network of trade built by his father. Even before the story begins, the sea has influenced the young Ben-Hur’s life in a decisive way. Ten years earlier, his father perished at sea on one of his business trips. Ben-Hur’s inheritance leaves him a wealthy “prince” of Jerusalem, yet he finds his life and freedom dominated by the Roman occupation of his native country. Ruthless Roman officials falsely convict him (without a trial) of trying to assassinate the Roman procurator. Judah is condemned to certain death as a galley slave.

Ben-Hur is literally lost at sea. As Wallace writes, “People, generally, are not aware of the ease of mind there is in knowing where they are, and where they are going.” Here, the author’s experience with war and military life shows through. Soldiers often must follow orders that are never explained and frequently travel through strange country without knowing their exact location or destination. Professionals working in today’s investment industry may be able to relate to this sense of disorientation, with the only reliable constant being constant change. Noting the degree of turmoil, CFA Institute President and CEO Paul Smith, CFA, said he had never seen anything like it in his 30-year career spanning Europe, the United States, and Asia. “The trend of commoditization and disintermediation in our industry points to a general lack of confidence in our ability to deliver value to investors,” he wrote in our March/April issue. But ethical investment professionals are far from helpless. In another column, Smith explained that “we have more influence than we think we do.”

Still, a KPMG study concluded that inexorable “megatrends” are already reshaping the investment industry and will completely transform it by 2030. One of the study’s authors, Tom Brown, told CFA Institute Magazine, “The big winner could be the investment management industry if it does embrace change. If it doesn’t, then another industry will step in and do the job for them.” When financial journalist and former analyst John Rubino examined the outlook for the next 10 years, he concluded that “the coming decade will see even more dramatic change than the previous one, with several trends (and trend reversals) likely to hit the investing world like earthquakes.”

Of course, a galley slave’s experience of disorientation would have been far worse. Ben-Hur knows only that he rows in a Roman ship. The slaves are never told where they are on what sea, in what action, or against what enemy. His only glimpses of the outside world come through a grate overhead.

A ray of hope shines into Ben-Hur’s life from an unexpected source. When pirates disrupt commercial traffic in the Aegean Sea, a whole Roman fleet is dispatched, with Ben-Hur at the oar of the flagship commanded by Roman tribune Quintus Arrius. After a long and distinguished naval career, Arrius has a dauntless attitude about fate and the unpredictable sea. Believing that “Knowledge leaves no room for chances,” his character has much in common with the kind of active investment manager described by Ralph Wanger, CFA, when he wrote, “Many of us decided to become CFA charterholders because we are brilliant, courageous risk takers and swashbuckling top-gun fighter pilots. Passive investing is for airline pilots.” Arrius trusts in discipline and meticulous preparation. Although he practices traditional Roman piety toward the gods, he believes “that the favor of the blind goddess [Fortune] depended more upon the votary’s care and judgment than upon his gifts and vows.”

In other words, he has a professional’s confidence in his own abilities. Yet, over the past year, even the most confident investment managers have had to pit their acumen against sudden squalls of market turbulence and uncertainty that, at times, threatened to capsize portfolios. Vincent McCarthy, CFA, summed up the situation when he wrote, “increased volatility points to a market that is finding it more difficult to appraise the consequences of the political posturing between Greece and the Eurozone, divergent monetary policy across the world’s major central banks, the recent oil price collapse, a lower global growth environment, and (most concerning) the risk of Europe becoming mired in deflation.” To design a more robust strategy for the prospect of increased volatility, McCarthy argued that portfolio managers should take a lesson from football managers.

In designing a strategy to find and defeat the pirates, Arrius has to deal with the volatility of the sea as well as the challenge of tracking a single flotilla without radar, GPS, or any technology better than ancient methods of reckoning and intuition. Like modern investors facing a persistent low-yield environment, Arrius has to make much from little. In the investment arena, the challenge includes navigating the “deep undercurrents” of negative interest rates. Investors also must contend with the perceived threat of deflation. In one survey of European buy-side managers, Fitch Ratings Fund and Asset Manager Rating Group found that fear of deflation was at “an all-time high.”

Being a shrewd risk manager, Arrius chooses a diversified strategy to hedge against different outcomes. He divides his force in half, even though doing so puts each squadron at a numerical disadvantage versus the combined pirates. The main force, commanded by Arrius, proceeds on the shortest route to attack the pirate fleet. The other half of the Roman fleet sails around a longer route and will arrive at the battle after Arrius has begun his attack. If Arrius fails and is defeated, his other force will find a damaged and depleted enemy. The tribune understands the difference between reckless aggression and a bold strategy. Likewise, the current investment environment has complicated the task of asset allocation and risk management. Fee structures have come under increasing pressure, leading many investors to move farther out on the risk spectrum in pursuit of returns. But are their investment decision-making processes up to the task? “The more we talk to people the more we realise that idea generation and portfolio construction are not always given enough emphasis as two separate aspects,” observed Kerrin Rosenberg, chief executive of the advisory firm Cardano UK.

The mission assigned to Arrius also has two aspects. One part is military: defeating and destroying the enemy. But the other part is driven entirely by the demands of commerce: restoring confidence. The pirate raids in multiple ports have brought international shipping to a standstill on the entire Aegean Sea. Coastal cities have shut down and closed their gates. As one observer comments, “The trade is so grown that it will not brook interruption a day.” Maintaining the empire depended in part on protecting business interests, some of which had become too big to fail. Today, we often hear about regulators and policymakers needing to maintain investors’ confidence in markets. Although some market participants may regard high-frequency traders as little better than pirates, the reality turns out to be far more complex for modern regulators. From concerns about shadow banking and systemic risk to dark trading’s impact on market structure and liquidity, regulatory challenges are evolving as fast as markets themselves.

Because of Rome’s need to maintain confidence in its ability to govern, the empire’s network of client states came with a tradeoff. As Wallace explains, “What Rome seized with strong hand she always defended: in return for their taxes, she gave them safety.” As long as Rome could provide security, its hegemony would continue. Then, as now, people valued stability. But according to Ian Bremmer, an expert on political risk, the global order of the 21st century has devolved into a “G-zero world” with a lack of effective international leadership. Thus, he predicts that investors will face “a period of dramatic geopolitical disorder” that will continue for at least a decade.

However, several interviews we published in the past year expressed a much more positive outlook for certain parts of the world. Good news is “the bit of the narrative people miss,” said Paul Clark, CFA, African equities specialist at Ashburton Investments in South Africa. As growth slows in some markets, it seems to be accelerating in others. For example, Punita Kumar-Sinha, CFA, expects India to surpass China as the fastest-growing large Asian economy over the next decade. Other observers also saw hopeful developments. Melissa Cook, CFA, and Walé Adeosun, CFA, believe investors need to develop a strategy for Africa or risk missing an entry point. “African economies may look small today, but growth is rapid and the opportunity cost of delaying is higher than it may seem,” said Cook. In Nigeria, Folasade (Sade) Odunaiya, CFA, predicted improving growth prospects for Africa’s largest market with a new president elected to bring reform.

In putting down the pirate menace, Arrius has one advantage over modern investors coping with uncertainty. Because the Romans and the pirates are equally equipped, he doesn’t have to worry about “an invasion of disruptive technology.” In our time, the rise of robo-advisers has put wealth managers under greater pressure to demonstrate how they add value for clients. A coming robotics revolution could bring IPO booms, economic dislocation, and fundamentally altered monetary policy. And recurring breaches of cybersecurity have raised serious question about the vulnerability of financial data. One security expert believes that complex systems are impossible to secure. Instead, the financial industry should design systems that will “fail gracefully.”

The battle plan of Quintus Arrius illustrates the principle of failing gracefully. As planned, his outnumbered squadron engages the pirates first, fighting a fiery battle in the dark of night. The flagship carrying Arrius and Ben-Hur is shattered and sunk. Ben-Hur saves the tribune from drowning. Cast adrift, the two have no idea which side won the battle, and the morning reveals a seascape littered with the wreckage of both Roman and pirate vessels. When a Roman ship eventually arrives on the scene and rescues the two men, Arrius learns that his strategy prevailed and his second squadron defeated the weakened pirate fleet. The victory leads to promotion for the Roman commander and liberation for Ben-Hur. Later in the story, looking out over the crowd in a large arena, Ben-Hur can be reminded of the perils he endured and think, “In the spectacle of a great assemblage of people there are always the bewilderment and fascination one feels while looking over a stretch of sea in agitation.”

Observers of global markets over the past year may understand the feeling.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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