June 10, 2010

Of Beach Balls and Risk Allocations

Sorry to keep you waiting two extra days this week! We were in San Diego, where June Gloom outside contrasted with the festive mood filling the Manchester Grand Hyatt for NIRI National 2010, the annual gathering of IR professionals.

Attendance jumped from last year. A few new firms joined the lineup on the boulevards in the exhibit hall. One first-time attendee working in corporate governance said as we sat by the fire pit Monday night and watched the party crowd and the live band and the oddity of the evening, a young woman rolling around on the pool in a giant see-through inflated ball, “You NIRI folks are the nicest conference goers I’ve ever met.”

Investor-relations types are people people. Who like to party.

There’s not a lot of partying in the equity markets yet. While the IR tribe whooped it up in San Diego, the markets didn’t. We’d expected better. We wrote two weeks ago that hedge resets on May 21 (think of them like climbing cams keeping you anchored to the rock face on Switzerland’s Eiger), signaled better things for a brief spell. But days later on May 26, something rippled portfolio trading schemes. Alert reader Eric Boni at Ashland Inc. said to us, “Could it be the MSCI rebalance?”

These rebalances and other forms of risk-management are often why markets seem schizophrenic. Last week on a similar jobs report to the one we got today the market kamikazes 300 points. Today, it’s up 2% so far. What gives?

There’s arbitrage, as we described last week. Compare big ETFs like QQQ, SPY and EEM, which track the Nasdaq 100, the S&P 500 and global emerging markets. You’d think they’d diverge more since they aren’t the same things. But with most trading behind them arbitrage, they look like each other instead of the segments they approximate. Or so it seems.

There’s also leverage. Back to MSCI. EEM, the ETF noted above, is an MSCI product in the iShares family bought by BlackRock from Barclays. It’s a $35 billion ETF that mirrors the MSCI Emerging Markets Index. MSCI was Morgan Stanley Capital International, a Morgan Stanley subsidiary that first created index investment products in 1969. In 2004, MSCI acquired Barra, Inc., a risk-analysis software firm, which combined to form publicly traded MSCI Inc. (NYSE:MXB), no longer affiliated with Morgan Stanley. In March this year, MSCI said it would acquire RiskMetrics, the risk-management and corporate governance giant.

Why are indices, ETFs, software, pieces of giant investment banks, and corporate governance rolled into one? Risk management is the biggest deal today. Yet investment managers must produce returns for clients. A white paper called The Perils of Parity from MSCI stuffed with terms like “empirical plausibility” and “derived conditions” explains that institutions have moved from allocating capital to allocating risk, and in so doing, leverage has become “necessary to achieve the expected return required by institutional investors.”

Suppose you met with investors and told them your growth story. But as you talked, the investors were thinking about how to allocate risk to you, not how to get a return from investing in your stock. That’s what software is doing today, and what these indices and ETFs are designed to do. So a bad jobs report last week in context of allocated risk was ugly for equities because the risk was allocated to stocks. This week, the risk is allocated somewhere else, and the capital gets allocated to equities. And the outcome is reversed.

Bottom line, you must pay attention to rebalances, IR folks, if only so you can talk briefly to the CFO about the difference between allocated risk and allocated capital. Next up on June 18, smack in the middle of options expirations, are the quarterly rebalances for the S&P 500, the Midcap 400, and the Smallcap 600. All of which have mirrored ETFs. And who knows where the risk and capital are allocated.

Maybe we need more swimming pools filled with inflated see-through beach balls ferrying flexible young females through happy partiers. It would make at least as much sense.

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