Risk Is Back – As Long as Central Banks Come Good on Promises

(August 14, 2012) — Investor confidence has taken its biggest monthly leap in three years as regulators and politicians have made the right noises, but this could all change if central banks do not fulfil their promises.

Allocations to equities, real estate and commodities have jumped this month since investors flocked to cash in July, according to a monthly survey by Bank of America Merrill Lynch.

A net 15% of investors responding to the survey said they believed the world economy would improve over the next 12 months. This represented a 28 percentage point swing and marked the most acute turnaround in confidence since May 2009, when the world emerged from the credit crunch, the bank said.

“August’s surge in confidence seems to be more a triumph of policy projection and potential than positive economic data,” said Gary Baker, head of European equities strategy at BofA Merrill Lynch Global Research. “As indicated by the survey, the risk is now that inaction by policy makers would lead to a negative reaction in global markets.”

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Respondents indicated they expected the European Central Bank would step in to help ease pressures in the Eurozone. This followed the bank’s president, Mario Draghi, announcing last month that the institution would do “whatever it takes” to bring financial stability back to the region. Critics have wondered when the bank is likely to take such action, however.

This confidence of resurgence in Europe was shown by investors either allocating more or expressing a desire to European stocks. Instead, the United States is proving a concern for investors, with more of them citing the nation’s fiscal cliff as the largest tail risk rather than the European debt crisis.

Bullish sentiment over real estate this month has seen the largest allocation to the asset class since January 2007, BoA Merrill Lynch said. Commodities saw positive sentiment with the percentage of investors underweight the asset class dropping from a net 13% to 2%.

Under the current fee structure, the optimal size for hedge fund performance differs substantially from the optimal size for managers’ compensation, a newly released academic paper concludes.

(August 12, 2012) — Hedge fund managers have strong incentives to increase fund sizes when it comes pay packets — but at what cost?

A recently released academic paper by Chengdong Yin of the University of California aims to answer that question. According to Yin, there is still a conflict of interest between fund managers and fund investors under the current hedge fund incentive contracts.

Yin concludes: “We first document that diseconomies of scale exist in the hedge fund industry, and thus optimal sizes in terms of fund performance can be identified. If the incentive fee contract is effective and managers behave in the investors’ interest, assets under management should be restricted around the optimal sizes for fund performance.”

He continues: “However, managers’ compensations are also related to fund sizes and our empirical results show that the optimal sizes for managers’ compensations are larger than the optimal sizes for fund performance.”

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In other words, according to the author, fund managers have strong incentives to increase fund assets, even when the growth of fund sizes will erode fund performance. The author concludes that in order to attract capital inflows and avoid capital outflows, fund managers need to maintain average performance.

Click here to read the full paper.

aiCIOrecently explored a new fee structure being implemented by the $6.5 billion Wyoming Retirement System, which says it’s time for “capital owners,” or public pension funds more specifically, to change the way they compensate their fund managers. At the moment, the managers are often the ones getting most of the benefits — even when they underperform, the fund’s investing heads said.

Thus, according to the public pension fund’s John Johnson, chief investment officer, and Jeffrey Straayer, a senior investment officer, the Wyoming scheme is changing its methodology of fund manager compensation. It has introduced a revised fee structure in a request for proposal in March and is expecting implementation by mid to late August. While traditionally, fund manager fee structures used by pension funds lead to overpaying managers when they’re doing well, managers maintain that payment when they’re underperforming, according to Johnson.

Jibing with some of the themes expressed in Yin’s paper, Johnson noted that most asset owners have fund manager fee structures that include a high fixed active fee with a performance fee added to it, which leads to a tendency among fund managers to index and gather assets to attain the highest fees. “That business model shifts risk to the pension fund rather than the risk being on the fund managers,” he said.