Newsnight appearance on 23 July

I appeared as a guest on BBC 2’s Newsnight programme on 23 July, in which Linda Yeuh, Max Wolff, Gavin Esler, and I discussed the European bank stress tests.

To view the clip go to the 'In the media' page.

Here is what I had to say:

• “I don’t think the tests were credible. I wouldn’t agree that the 0.4% reduction in GDP, which they looked at as an economic downturn, as a double-dip, is the worst that you could realistically envision and when you look at what we’ve already had that’s a small fraction of what could occur frankly.”
• On the stress tests: “This looks like an exercise in firing an arrow and then drawing a target around it.”
• “One of the great differences between American stress tests and the European stress tests is that clearly in the United States it’s not necessary to apply a sovereign default as being a likely outcome.”
• On the absence of stress tests for a sovereign default: “ Do I regard it as something that you can take as an assumption that because the European Central Bank says it will do anything to prevent a default that there won’t be one? No.”
• “Nothing has changed of any significance in the structure of banking in Europe or the United States in terms of those parts of the structure which contributed to the crisis – nothing whatsoever.”

Comments

[Tom Austin]

Hi,

I am an individual investor (US) who recently added more money to Hedge funds (20% of portfolio) and managed futures (10% of portfolio) even though I am not super comfortable with them due to moral hazard, information asymmetry, fee structure, etc. You know more about markets than I do.

Having said that, I still want to point out that the Warren Buffett analysis you offer is somewhat misleading. I downloaded the excel spreadsheet and ran some quick analysis. First, the 20% performance fee is only when returns are positive (most, if not all, managers don't share in losses as you point out), so I modified this column. I then summed just the fees paid to the managers. Buffett would have been paid $221,547.03 over this time period. The investor would have earned $360,864.98.

This is an average annual return of 14.56% with an SD of 12% and max DD of 11.41% (1x in 2008). I would have gladly taken this. If I could get 7% return after fee and tax and 12% SD and max DD of 20%, I would take this over coming 20 years.

The returns you calculate assume that the investor and/or Buffet also invested all of these 'fees' in the fund. This is not really a 'true cost' to the investor. It is more like an 'opportunity cost' to the investor if they had been able to invest exactly like Buffet without him. It also assumed no costs to Buffet in terms of organizational costs (due diligence, site visits, etc). For a hedge fund with large AUM this may be close to true. For an individual investor it is not. It is hard to run a no cost 'hedge fund' clone for an individual. That is why we pay fees.

Key I want from my allocations is a) lower portfolio volatility, b) limit on major drawdowns, c) independent thinking and ideas and d) no major fund blow-ups (mitigated through risk allocation to managers limited at 3-5% of total portf) and e) low correlation through independent thinking. What I really want is 'under the radar' great managers with track records and strong risk controls launching newer, smaller funds.

I have tried to seek out funds that are doing things I can't and might offer non-correlation. This is in areas like a) managed futures (although huge inflows to sector has me worried about large fall off in returns and I know there is large historic fund failure rate), b) event driven and financial sector recovery c) fund of funds. Funds like QIM and Paulson meet criteria of manager having large percent of assets in the fund although not under same terms (they don't pay me a fee for their assets).

I just point this out as, for an individual investor, who needs a 4-5% real return, wants to control drawdowns (under 20%) and is not super bullish on equities over 10 years and is not in love with fixed income for long-term (due to risk of rising interest rates and inflation risks), there is a need to put some money elsewhere.

Best,
Tom

[Terry Smith]

Tom, thanks for the comment. I don't think the Buffett example is misleading. It assumes that the investor and the manager receive the same return. In practice many hedge fund managers do build a stake in their fund by retaining their fees in it. In fact, I suspect that my example errs on the side of being too kind to the managers, since many hedge fund managers having built their stake in the fund from their 2 and 20 then cash out some or all of their investors, who are thereby denied access to any future compounding. And for an investor to be willing to pay the manager $221K for returns of $360K, as you suggest, strikes me as a totally unreasonable division of risk and reward.