May 4, 2010

It May Not Be About You

In Denver we get sun, rain, snow, sleet, hail. And then comes the next day. Today, a clear, bright and breezy 75 degrees Fahrenheit, photographers out snapping chamber of commerce pictures, the power goes out. It’s put us behind schedule.

Speaking of power outages, starting April 22 equity markets developed voltage problems. IR professionals, we’ve got two words for when you meet the CFO in the hallway and she asks, “What’s up with the stock market?”

Risk Management. What two words did you think we were going to offer? “Risk Management” is why the same stocks that were up yesterday can be down today. We saw surging European and Asian inflows April 22, and a reversal of the same inflows on April 27.

From the IR chair, it’s flummoxing. Your nearest peer, in the same industry, about the same market cap, doing similar things, reports results on April 22 and beats expectations and soars 10% in a day. You then report the same good results almost pound-for-pound, a handy beat. And your stock declines three percent.

What gives?

Time for those two words: “Risk Management.” Large portfolio trading schemes such as pension and investment funds may hold an array of securities. Let’s say euro-zone bonds, currency futures, US Treasuries and US growth stocks. Suppose these investments are protected with risk metrics software from SAS, and trading-desk level systems from prime brokers JP Morgan and Deutsche Bank. These systems are designed to monitor and maintain portfolio risk and return within certain parameters.

Greece’s bailout is approved. The systems determine that this will strengthen the US dollar, thus weakening inflows to US equities from European and Asian sources. The systems themselves execute automated trades, complete with offsetting derivatives, to control risk.

This behavior causes a domino effect. The same securities the system said to buy last week are now the ones it sells. That triggers other limit orders and stop-losses, changes the nature and size of passive market-making trades, and attracts statistical arbitragers finding fleeting imbalances. And because ONE variable in the overall risk-management schematic is different – maybe a risk metric is the ratio of dollars on reserve at the European Central Bank, which has just returned a bundle of them to the US Federal Reserve – it over-corrects.

The next day, the system tries to rebalance the overcorrection, producing a spike in US securities again. Commentators bray about renewed enthusiasm for US economic growth, which in fact plays almost no role. Leveraged ETFs had just today adapted to yesterday’s big risk-management change. Now those are out of balance.

Suddenly, inefficiencies abound. Passive market-making systems aren’t getting liquidity to the right spots fast enough. Stat arbs are executing simultaneous offsetting trades in ten different market centers, creating the illusion of movement where none exists.

And the next day, the risk-management system tries to rebalance again.

This is how you get great volatility in markets designed to function smoothly and efficiently.

You don’t need to explain it in detail to your CFO. But you should be able to say, “We have integrated global markets. Our results, which were great for our active investors, now are secondary to global risk management. That’s the reason we’re under pressure. It’s a portfolio problem.”

But portfolio problems are our problems too. What’s the answer? We invite your suggestions. Meantime, be sure management doesn’t take it personally. It’s not always about you.

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