Posts Tagged ‘Risk management’

Are smart markets better markets?

Friday, January 29th, 2010

Smart people have come into finance. But contrary to what economic theory suggests, the increased IQ hasn’t stabilised markets. In fact, argues Professor Harrison Hong, it seems they have returned to the kind of instability associated with stock markets around 100 years ago.

If you really want to know why the financial system nearly collapsed in the fall of 2008, I can tell you in one sentence… because smart guys had started working on Wall Street.’
Calvin Trillin, ‘Wall Street Smarts’ New York Times, October 13, 2009

In the past 30 years, the people working in finance have become smarter and smarter. Like moths to a light bulb, the world’s best and brightest have been drawn to Wall Street by astronomical rewards. Three Nobel Prizes in less than 20 years awarded for advances in financial engineering for the capital markets; skyrocketing numbers of PhDs and Masters in finance globally; and technological advances in capital markets, which have greatly outstripped those in other industries, attest to the brain power that has made its way into this industry over others.

But contrary to what traditional economics – in the form of the efficient markets hypothesis – would suggest, smart thinking and smart practice have not brought market stability. In fact, the bubbles and troughs that we see today are as frequent and as destabilising as those that characterised the less mature and more fragmented markets at the beginning of the evolution of capital markets a century ago.

What gives?

It turns out that the very cleverness that makes markets much more efficient than they used to be also affects their stability and robustness. Because market participants are smarter, they switch on to trends much faster – they pile in on the way up and bail out on the way down much faster than they used to. This affects volatility and makes markets much more prone to bubbles and busts.

The smartest guys in the room

Evidence that clever people have been attracted to the finance sector is clear.

For instance, in 1972 only five percent of Harvard undergraduates went into finance. By 1992, that had risen to 15 percent and approached nearly 20 percent in 2007. More broadly, the number of PhDs and Masters in finance awarded internationally has also grown.

It’s no mystery why. Financial incentives are significant. Prior to the 2008 crash, wages in finance were on average 40 percent higher than wages in other industries. But averages are one thing and they don’t emphasise enough the impact of the massive packages received by those at the top.

At the same time, there has been an increasing trend in the professionalisation of asset managers, with more people managing investments on behalf of others (individuals or organisations) with direct ownership of shares in the US equity market dropping from 47.9 percent in 1981 to 21.5 percent in 2007.

All this financial innovation has been complemented and accelerated by innovations in information technology. Asset prices respond to news faster than ever and markets are deeper, more integrated and increasingly globalised.

The cost of trading has dropped to a fraction of its previous cost and there has been an explosion in turnover, peaking at 215 percent (in the US) in 2007.

According to the efficient markets hypothesis, markets are informationally efficient – meaning that the price of a financial asset reflects all the information known about it. The asset price will change rapidly whenever new information becomes available. The smarter people are, the quicker they can unearth, interpret and make information available. Combine this with the 30-year revolution in communications technology that enables rapid – almost instant – dissemination of information, and you’d expect the smarter the markets become, the better they will be in terms of reaching true value pricing for assets faster and more accurately. The rapid availability of high quality information means efficient pricing and increased market stability.

Despite all this, the bubbles and crises in the markets have been coming more frequently. In some cases – such as the collapse of Long-Term Capital Management (LTCM) at the end of the 1990s, and more recently the subprime mortgage crisis, the smart guys have been directly implicated. After all, having Myron Scholes and Robert Merton – two Nobel Prize laureates for Economic Sciences – on the board of LTCM clearly didn’t prevent the company’s collapse.

So why are our supposedly sophisticated, agile and technologically advanced markets behaving in a way that is reminiscent of markets at the turn of the 19th century?

Momentum, competition and risk

In essence, there are three reasons why a large number of smart people makes markets more fragile. Firstly, more smart trend spotting means more momentum, both on the way up, and on the way down. Secondly and thirdly, the nature of competition on Wall Street, and the way practioners are compensated, both lead to riskier behaviour.

One of the things the smart guys have worked out is that following a trend – aka ‘momentum investing’ – is a profitable investment strategy. For example, if technology stocks are on an upward trend, it’s profitable to follow the trend and invest in technology stocks. The upward trend in prices will continue to a certain point. Of course, no one can accurately predict when this point is reached. There is likely to be eventual overshooting as the later trend chasers push the asset price beyond what the fundamentals would suggest its true value to be.

Nonetheless, trend chasing remains profitable on average, because even in smart markets, some people catch on quicker than others. Later investors – the ones that get the news last, or are slowest to act on it – stand to lose.

By identifying the profitability of trend chasing, the smart guys have popularised an investment strategy that, while largely profitable, creates price bubbles. Bubbles burst leading to market instability and, in the worst cases, market collapse.

Another way in which increased IQ on Wall Street contributes to instability is through competitive pressure, leading to risky behaviour. Job insecurity on Wall Street is higher than in other sectors, and it has increased in recent years due to the liquid labour market. This lack of security pushes ambitious traders towards strategies that yield profits with less regard for risk. And when employees are smarter than their managers, some of their actions or the nature of the risks they are taking may not be easily visible or readily understood.

What’s more, excessive compensation encourages risky behaviour, which throws wood on the fire; the amount of risk-taking that leverage enables, adds gasoline; and the conflicts of interest that emerge in some of the big finance institutions (for example, competing in two sides of a market trade such as buying and selling mortgages), further fan the flames.

So are smarter markets better markets?

Markets are as susceptible to bubbles and troughs as they were when they were much slower in their operation. But for very different reasons. Nonetheless, the genie won’t go back in the bottle. Governments cannot regulate IQ or employment patterns. But they can influence the rules of the game to decrease the attractiveness of risky behaviour and eliminate conflicts of interest.

Cafe21C: The Australian film industry

Friday, January 29th, 2010

This feature was broadcast on the ABC’s Big Ideas program on July 13, 2010.

Business21C invited three pillars of the Australian film industry for a cup of coffee. Stephan Elliott, Peter Ivany and Troy Lum talked about why film is such a risky business, which may explain why its players are perversely risk-averse.

In Cafe21c we have:

  • STEPHAN ELLIOTT: Writer/Director. Credits include The Adventures of Priscilla, Queen of the Desert, and most recently Easy Virtue.
  • PETER IVANY: Private investor. As former CEO of Hoyts Cinemas, Ivany grew the company from a 40-cinema chain in 1988 to a global business with more than 2,000 theatres operating in 12 countries. Ivany is chairman of the Sydney Film Festival.
  • TROY LUM: Managing Director, Hopscotch Films. Lum founded Hopscotch Films in 2002, after a five-year stint as head of independent film distributor, Dendy Films.

How does the film industry work? What is involved in putting together a movie?

ELLIOTT: As a writer/director, I’m very lucky that I’m usually not out hunting for material – I generate my own which is a very big plus. I’ll get to a point where I’m happy with a script, and then we take the big jump and start looking for a producer and money. For me, the most successful place to do this has been the Cannes Film Festival. And Troy Lum is usually one of the first people I bump into.

LUM: I do six festivals a year. I have a hit list and I’ll constantly track films. I’m out there searching for projects; I’m looking for material that I can get involved in straight away and I try to circumvent my competition. In the case of Easy Virtue, I was involved in the film years before it started production.

IVANY: Once a film is made, a cinema exhibitor needs to decide how many screens it will devote to it and when to play it, against all the other products around at that time. One of the important things for a film is how many minimum weeks we give it to play, so the distributors have a chance of getting all their marketing expenses back and the producers and investors have got a chance to get their money back.

What makes a good project?

LUM: We’re very material focused at Hopscotch. It is very much about the script, the emotional response and matching that with a director. We’ve seen many good scripts turn into bad films through poor handling. I think a director is the most important element that you can have in a film.

ELLIOTT: But that’s very much Troy. A lot of other companies are completely the opposite. The bottom line is they don’t care who is directing, they want to know who’s in it. Troy’s attitude is quite unique.

IVANY: It’s a very imprecise science. Most films don’t last a long time, and so you look for a whole range of things. A good story is great but if it’s poorly executed, then it doesn’t work. There’s another element that’s important: how many marketing dollars are put behind the film. That’s where the studios have a significant advantage because they can promote a film with a big enough budget to ensure that it at least has a healthy opening.

What type of person is successful in film, what attributes do they have? Is it a lot of persistence? A capability for uncertainty? Is it luck?

LUM: There’s an element of luck. As a distributor you’ve got to be able to inspire confidence in people around you. I don’t think I’m much better than many other people at picking films. What I do think I’m good at, is I’m good with people. The business is built upon relationships, maintaining goodwill and being trustworthy.

ELLIOTT: We’ve all been struck by luck once or twice. Priscilla was a moment in time and a moment in the market. I saw the hole and I wrote the film for that hole because nobody else had. Now that was luck.

IVANY: The people that have sustainable success in this business are no different to those in any other business. The people that have sustained luck over many years are actually good at their craft, very disciplined and hard working.

In such an unpredictable business, how do you invest and manage risk?

IVANY: The quality of information you can expect as an investor in film is very low. It’s a creative industry and you’d like to get the same level of information that you would in other industries, but you just don’t.

LUM: You have to acknowledge that the business is up and down. My philosophy is to be really calm. You can’t think that the business is something that it’s not. You lose money on many films. What matters is how much you lose. At the same time, when you’ve got something good, you’ve got to invest – you might have five films coming out in six months but you might have one that is the ultimate. You’ve got to know what you have and be very considered about it.

IVANY: Troy’s unique because, in the film industry, when you’ve got executives and people around you, success has many fathers and failure is an orphan. They do get carried away and I think that’s one of the issues. But you’re also in a competitive process. You’re bidding for films you’ve not seen against other people and so you have to keep a measured view.

ELLIOTT: Harvey Weinstein’s (co-founder of Miramax Films) attitude was to make 10 films, with the view that one of them will strike. He just kept making a slate of 10, 10, 10, and the model worked.

How much of a threat is digital piracy to the industry?

LUM: It’s hard to measure how much of a threat it is but I think it’s very hard in the modern world to stop people from getting what they want. The windows between cinema, video and television are just going to have to collapse. If we’re not monetising the fact that our nephew wants to see Twilight on day one on his mobile phone, then we are losing money. We have to accept that that’s just the reality of the situation. Let’s get into the process of actually trying to work out how to make money from it.

ELLIOTT: The film industry is just going into it now but the music industry has near on collapsed in the last couple of years, and they are reinventing the wheel. The film industry is not far behind. So it’s moving, and who knows where it’s going but it’s going to be shaky times.

IVANY: Piracy is a huge problem because it devalues the commodity. The issue will be whether there is worldwide, coordinated action to tackle it. This will be difficult, because of the different legislative jurisdictions involved. Pirates bypass copyright legislation by operating in different countries. The problem is, the films they pirate get distributed internationally. Ultimately it’s going to be up to the industry to figure out a way it can control its product. They’ve got the most to lose because the industry could dissipate and there won’t be money to make new films.

LUM: If The Twilight Saga: New Moon was available immediately to everybody but it was more expensive to watch in your house than it was to go to the cinema, then kids would go to the cinema. The problem is that we don’t control it from day one.

What is Australia’s role in the international film industry?

ELLIOTT: At the moment, we’ve gone back to one of those bad cycles of making a lot of kitchen sink dramas. The bottom line is that nobody is going to see these films. If they do the maths and can work out what’s going to make a big noise, then we could have an explosion of Australian cinema again and I believe we’re right on the cusp of that at the moment.

IVANY: I think the Australian film and television industry is in reasonably good shape. There’s a strong demand for Australian product, both domestically and to an extent overseas. There is government support, although I think that will need to be increased if we want to maintain our position in the global film industry. I’d like to see more encouragement for risk. We have to create a framework that enables people to take more risks and be rewarded.

LUM: We’ve got the talent here. We’re just limited by our ideas. We don’t care where the films are from; we just want the films to have a good idea, good audience emotional involvement, and at the moment, we’re not thinking in those terms. It’s not about being Australian. It’s about having the breadth of ideas in cinema that people want to go and see.

Cafe21C: The inadequacy of economics

Wednesday, October 28th, 2009

In the first of our Cafe21C interview series, B21C editor Mike Hanley talks to Dr Paul Woolley, founder of the Paul Woolley Centre for Capital Market Dysfunctionality at the London School of Economics, the University of Toulouse, and UTS; Ron Bird, Professor of Finance and Economics at UTS: Business, and Jack Gray, Adjunct Professor of Economics at UTS: Business.

The conversation ranged across the gamut of economics, from the inadequacy of the efficient markets hypothesis, through the impact of agents on the size of the financial markets and their efficiency, through to policy prescriptions to avoid another crisis.

Capital market dysfunctionality conference: Living online library

Wednesday, October 28th, 2009

Above is an interactive feature containing overviews of the speakers and subjects covered at the Capital Market Dysfunctionality Conference at UTS, in October 2009. Please use its inner navigation to interact with its content. The feature is also a living library containing the papers delivered at the conference, and we ask attendees and others to add reference resources – to enable it to grow during the conference and beyond, as a research and teaching aid.

The Global Financial Crisis began with a series of financial and economic imbalances which had developed at an increasingly frenetic pace over recent years. The first bubble to burst was in the US housing market and the consequences spread across asset classes and geographies like a series of tumbling dominos, each one taking down others as it fell, the momentum gathering and the impact of each collapse magnifying.

The widespread use of financial engineering to distribute risk, combined with the massive leverage that had been allowed to build in the system, fiscal policies, national economies and financial institutions were exposed as relying excessively on best case scenarios and inadequately prepared to cope with the crisis.

We had borrowed too much, against assets that were priced too high. When the good times were over, prices fell, and debts were called in. The global economy was caught short – from suburban mortgage borrowers, to international financial powerhouses, we didn’t have the cash to get out of debt and we couldn’t sell what we owned at a high enough price to cover what we owed.

How academics, policy makers and financial practitioners come to understand how a collapse on such a scale was possible, will largely determine what the response – if any – is appropriate.

The following conversation is the first of our Cafe21C interview series. B21C editor Mike Hanley talks to Dr Paul Woolley, founder of the Paul Woolley Centre for Capital Market Dysfunctionality at the London School of Economics, the University of Toulouse, and UTS; Ron Bird, Professor of Finance and Economics at UTS: Business, and Jack Gray, Adjunct Professor of Economics at UTS: Business. The topics ranged across the gamut of economics, from the inadequacy of the efficient markets hypothesis, through the impact of agents on the size of the financial markets and their efficiency, through to policy prescriptions to avoid another crisis.

Australians deserve leaders who are willing to take risks

Friday, September 25th, 2009

The best leaders give their people enough rope. Associate Professor Julia Connell, Director of the Graduate School of Business, UTS, wonders why more leaders aren’t able to tap into the well of creativity sitting inside their organisations.

One of the best leaders I have ever met is Nigel Whitehead, then BAE Systems Director of the Lead-in Fighter Project at Williamtown, just outside of Newcastle. A business leader responsible for multi-billion dollar projects and 1,000 employees at the time, Nigel developed a charter for the ‘greenfield’ organisation.

Once recruited, a planning team was formed and ‘a blank sheet’ was placed in front of them. The team were given a budget and a timeframe and told: “This is your facility, you design what you want and we will build it for you.” What followed was a tremendous outpouring of creativity. The Williamtown building was built to last; utilitarian, but also aesthetically pleasing. Since the BAE employees created it, there was a great sense of pride in their achievement and they kept it immaculate. If Nigel thought there were too many procedures in place that obscured the strategic vision he rewrote them rather than become bogged down. He was resolute about not working to an organisational chart, arguing that charts can stifle creativity. A major 3-year project was completed without anyone once drawing a chart. “No one ever asked for one,” he said. “Everyone understood their roles and responsibilities, although those roles were often switched day to day as there was a sense of fluidity”.

Nigel believed his role as a leader was to inspire the efforts of others, generate enthusiasm about what could be achieved and create a sense of purpose. He firmly believed that for people to be developed to their full potential they needed to undertake ‘scary jobs’.

“Scary jobs make people opinion makers, show their mettle and get them out of their comfort zone. They get used to the fact that everything is potentially dangerous, live by their wits and get on-the-job training through a voyage of discovery. I might say to someone, ‘you will struggle with the skills you have today but we will coach you and you will do better and eventually be a bigger person’.

A leadership style such as Nigel’s requires an element of risk and trust but the rewards in terms of employee engagement are clear. Others, such as Ricardo Semler, have gone much further as in his organisation Semco employees can decide on their own working hours, choose their own salaries and hire their own bosses among other initiatives.

Yet leadership styles and strategies such as this are the exception not the rule

A 2007 report commissioned by Manpower surveyed more than 16,000 workers. The study measured commitment, pride, advocacy and satisfaction, in order to assess the extent employees felt engaged with their organisation and their job. Over 2,000 Australian workers were included in the survey. It found that 62% of Australian respondents were disengaged at work, with 42% of employees describing themselves as “disconnected” – neither engaged nor happy at work. Only 36% of Australian workers said they felt connected to their job and described their organisation as a great place to work. These figures are similar to those cited in other large surveys on engagement, including surveys by Towers Perrin, The Leadership Council, Gallup and others.

Surveys such as Manpower’s indicate that many Australian business systems are not providing workplace environments where employee engagement is the norm. It seems evident that more Australian leaders need to be brave and seek new ways of engaging their people and tapping into the massive pool of discretionary effort they could offer. After all it may make all the difference between organisational survival or demise.

This is a summary of a presentation given by Associate Professor Julia Connell at a Panel presentation: “Do Australian Business Systems Fail Our Best People?”, at UTS: Business on September 10, 2009.

Forensic accounting: Bringing research and practice together

Tuesday, August 18th, 2009

Detection of accounting manipulation is a priority for many groups, including investors, auditors and regulators. UTS researchers are combining academic insights with practical tools to identify cases of ‘earnings management’ explains Professor Stephen Taylor.

In the last two decades, academics have done extensive research into the possible causes and consequences of accounting manipulation (also known as aggressive accounting). But until recently, most studies have focused on creating a systematic model of unusual accounting activity, rather than one which has powerful applications in the real world.

Understandably, researchers have been concerned with avoiding type I errors (that is, falsely classifying companies as manipulators). But in practice, investors, regulators and auditors are far more concerned with the power of methods to detect aggressive accounting than they are with wrongly concluding that some firms have engaged in the activity.

According to Professor Stephen Taylor, ‘An auditor who misses something wrong faces potentially huge costs through liability and resulting litigation, as well as damage to reputation.

Research conducted by Taylor and former PhD student, Luke Bayley, and supported by the Capital Markets CRC, is an attempt to refocus efforts on the most practical level of concern: the ability to recognise flagrant earnings overstatements.

‘What we’re trying to do is reorient the research focus to one that fits better with practitioners problems: the fact is that missing something thats actually occurring is far more costly than wrongly concluding that something is happening.

To do this, they have developed a measure (labelled as an EM-score) based on simple accruals, supplemented by some measures derived from financial statement analysis techniques. The variables include a selection of ratios directed at the detection of either premature revenue recognition or increased cost deferral. They reflect analysis of the following indicators:

  • changes in sales,
  • divergence between accruals and cash flows,
  • inventory changes,
  • changes in bad debts reserves, and
  • changes in asset quality.

‘Our approach is to combine the insights from the existing academic research with what we teach in the classroom – the practical analysis of financial statements.

‘We’re trying to do research that is of practical relevance to auditors, financial analysts, the investment community and anyone who relies on reported accounting numbers as input into their decisions.’

In practice, most concern revolves around the overstatement of earnings – it is extremely rare to find an auditor subject to legal action over the alleged understatement of earnings. In cases where analysis suggests that earnings are overstated, an auditor can do additional analysis to verify their results. The cost of this additional analysis is likely to be far lower than the exposure resulting from a subsequent realisation of an undetected overstatement.

Until now, the most influential model for detecting earnings management has been the expected accruals approach identified by Jennifer Jones in 1991. Research suggests that unexpected accrual measures only separate the most extreme examples of manipulation, whereas the EM model is better able to distinguish earnings management across a sample of cases. In contrast to prior research examining extensions of the Jones model, this EM test focuses on methods for detecting substantial upwards earnings management.

In their paper, Identifying Earnings Overstatements: A practical test, Bayley and Taylor demonstrate that a combination of a simple measure of accruals with some straightforward financial ratios analysis can successfully distinguish between firms alleged to engage in quite serious earnings management, relative to a set of matched control firms.

However, their primary contribution lies not in the recognition that financial statement analysis techniques are useful for identifying upwards earnings management, but in demonstrating how little power conventional models of unexpected accruals have.

Stephen Taylor says, ‘Although it is entirely appropriate that researchers are concerned with avoiding type Ι errors, it is equally apparent that users of financial reports (including auditors) are far more concerned with the need to avoid type ΙΙ errors.’

‘The research reflects a view that we can’t ignore the needs of the profession. We’re trying to reorient our research at UTS in a way that has both academic rigour and practical relevance.’