Nov 29

Dubai the Current Concern, but Not the Most Important

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Far be it from me to improve upon the excellent, though government shielded, coverage of the credit default originating in Dubai. Apparently rooted in a hangover from a major commercial building boom, this default does have some parallels in Western economies.

But, we must once again raise the issue of credit default swaps and counter party risk. Worldwide, zombie banks, propped up by their local governments and tending to survival instead of lending, are showing good profits from trading. And that trading is tied to the ‘risk trade’ – both on and off- balance sheet manuevers using derivatives, including credit default swaps.
As in the days of Lehman and Bear Stearns, investors do not have a good clue as to the exposure in these instruments (direct and indirect) at these largest of institutions. Yet, we insurers dutifully list every single investment and credit derivative exposure on our annual statements. Well, I guess transparency is only good for certain regulated institutions…
Meanwhile, certainly the current Dubai incident may be prompting a call to your investment manager, or at least a glance at the latest portfolio holdings. But, as we continue to state, the key to solid investment results is a solid investment process. And, that includes understanding, in advance, how your company’s investment process is designed to deal with shocks (large and small) to financial markets.
This fact is so important that I’ve written a book about it, called Uncertain Times: A Chief Investment Officer’s Journey.
In reality, many insurers may be focusing on the investment manager at the expense of the investment process. David Holmes’ excellent Asset Outsourcing Exchange registered a strong 64% increase in number of manager searches by insurers, this year to date versus last year.
But, to the extent these searches are replacements of investment managers, one must wonder. To what end result?
Insurance companies rightfully provide a benchmark for the manager and the manager typically refuses to stray far from that benchmark. (You’ve probably heard the overused, ‘we try to hit singles, not home runs’ from managers.) With that approach in mind, can the manager truly add large amounts of value? The answer is an unequivocal, no.
The key to adding lasting, significant value is improving the investment process.
Think of it this way. The manager is like the mechanic who can fine tune your car and keep it running well. And the investment process is like the car. But, if you’ve got a VW Beetle, you really don’t have much of a chance of winning the Indy 500, do you? And, if your investment process seems to be running okay to you, perhaps you are simply settling for satisfactory Beetle-like performance?
We can tell you stories of companies that realize this and have seen rather impressive, documented improvements in investment results directly tied to improvements in their investment process.
But, the more interesting stories, quite frankly, are those companies that only get concerned when their manager ‘under performs’ or they have to deal with ‘impairments’.
The ‘risk trade’, where any security carrying credit or other risk has done quite well since March of this year, has buoyed the performance of many an investment manager. And, where Boards may have been very concerned about investments in Q4, 2008 and Q1, 2009, those concerns have somewhat ebbed due to the ‘risk trade’. Alas, that is truly a short sighted view. 
The question all Boards should be asking now must include, “how will our investment process deal with the next ‘shock’ to the system?” And this is a small part of a larger look at the overall investment process.
What should your company be focusing on now? How the (mechanic) manager performs or how well your (automobile) investment process is built?
As Dubai’s friends in the Middle East might say, “Happy Motoring!”