The decision to do nothing is still a decision…

My latest blog introduces a long-held area of personal interest and an emerging area of activity for our firm: that of assisting market-exposed clients establish frameworks that lead to more bankable performance compared with alternatives (including doing nothing).

In making the introduction I’m going to take the risk of leaning on the super-dry topic of decision-making under uncertainty in an attempt to explain how robust frameworks can promote higher-quality outcomes.

Along the way I’m going to unpack and focus on the question of hedging and the decision to ‘hedge’ (literally anything) in an effort to reinforce some key points.

Frameworks matter

Have you ever apprehended the arm-rest of a perfectly healthy airline seat while pretending not to be nervous in strong turbulence at 45,000 ft?

Let’s be honest: there’s no fun in being pitched around the ceiling, and you probably weren’t alone in choking that arm-rest. Some of your fellow passengers are likely to have suppressed an urge to scream; others are likely to have considered some futile assault on the cockpit door.

Don’t believe me? Try Googling ‘crazy reactions to strong turbulence.’

Aside from the fact that modern cockpits have sophisticated locking mechanisms, the good news is that your decision to do absolutely nothing turned out to be the best decision you could make.

Why?

Because decision-making frameworks with flight-controls and safety-protocols honed in various fields of science, backed by a hundred-plus years of controlled-flight data, were set by experts long before you bought your ticket. The risk of a modern jet-liner crashing from turbulence, even the heaviest most randomly experienced, is today so small it doesn’t register in International Civil Aviation Organization data.

Arm-rests aside, the modern air traveller has no need for turbulence-hedges.

Frameworks matter in finance (a lot)

 Before I try and connect the quirks of aviation to the world of financial markets, ask yourself: would frameworks and protocols matter if instead of being crowded into an A-380 you were a passenger in a single-engine Cirrus SF50 Vision?

The answer is: they still matter. Size doesn’t make much difference when you’re dealing with gravity at 45,00 ft.

While the flight and safety protocols of the Cirrus may be different, the key point is that a framework is still crucial, perhaps even more so considering the 1,610kg SF50 has only one engine and no co-pilot.

Which brings me back to financial markets and the need for parties to be able to negotiate market turbulence: can the kind of lessons learned in distant fields like flight and engineering be turned profitably to use in financial markets?

My answer is a question: why not?

Operations Research has led us

Operations Research is the branch of knowledge that deals with methods to improve decision-making with an emphasis on advanced analytical methods. Why it is not so well known in financial circles is something of a mystery, but it is one of the key disciplines that have helped important fields make the world a better, typically safer place.

Consider this: the collected benefit of OR, from its earliest practical application in the desperate months of wartime Britain, to its influence on modern decision-making in healthcare, is hardly appreciated when it is even known to people in finance. Yet, like the opening-up of mass air-travel and the winning of wars, the potential value of better decision making in finance should not be underestimated. 

While OR is not instantly recognisable it can be applied to almost any field (and typically already has), and some apply it without realising it, others are applying it haphazardly.

We are starting to simply apply it to add value.

Hedging as one example

My interest in financial markets was sparked by the realisation that portfolio management involved decision-making under uncertainty. The more important the decision, the greater the uncertainty; the more I liked it.

At various times my roles involved the tricky decision of whether to hedge certain elements of businesses that I ran or was involved in. This led me to think about how to apply OR and other tools to aid my decision making, I found that without a robust framework I was lost at sea, or to resubmit the aviation theme; I was mostly bouncing around in market turbulence without a parachute.

Imagine you’re an investment-manager running a partially-international investment portfolio, and let’s say the USD exposure of your portfolio averages 33% through time (which is a bit low compared to a recent well-regarded National Australia Bank survey).

Market-savvy, you’re likely to know a bunch of things already:

1.       The 30-year annual calendar-year Hi-Lo range of the AUD/USD exchange rate is conservatively around 18% p.a., let’s stick with that,

2.       Higher than average ranges occur approximately once every three years, and these average 31.1% (annual ranges) when they do occur.  

Seated in the investment-manager role (it could just as easily be an import or export treasury role) you could infer some simple expectations based on the original market-neutral framework of Black-Scholes (ignoring logs, things are as likely to go up as down):

·       Your USD-linked portfolio is impacted by higher-range years on average once every three years

·       Average calendar years can be expected to result in moves of around 9% up or down

·       High-range years can be expected to produce moves of 15.6% up or down

All of which is unremarkable; but consider these points from back-of-the-envelope calcs:

·       At some point in your average year the USD-linked portfolio can reasonably be expected to either drag or enhance portfolio returns in the order of +/- 2.97%

·       In a high-range year the drag or enhancement can be expected in the order of +/- 5.13%

The point to be made here is that the decision to hedge or not hedge exposure is consequential.

A separate but related point is that for those exposed to the Federal Government’s YFYS framework (Your Future Your Super) the hedging decision may be of heightened interest given that it takes YFYS managers further into a relative-performance arena.

That is: consequential decisions, whether well-formed or pot-luck, will be open to heightened scrutiny in a competitive sector that rarely produces net returns above 9% p.a. (7-year net p.a.). 

So, what’s your framework?

Our experience has informed our approach, and that is to start by asking our clients some really simple questions, allowing them to self-test their current approach even if they never engage us:

1.       Does uncertainty drive consequential outcomes?

2.       If consequential, do you seek gain or protection from the exposure?

3.       Do you have an existing framework to achieve what you seek?

And so forth….

What we all too occasionally find is that even where well-considered frameworks have been established the currency hedging-decision is often unloved, and often taken as a separate decision rather than a high-quality element of a high-quality investment management process.

To mention a few of the challenges we see firms not addressing well are:

·       Some firms evidence framework-rigidity, others exceptional latitude (are we running a hedge fund?)

·       Robust approaches to determining currency cheap/dear are often strewn across multiple spreadsheets owned by multiple decision-makers – i.e., the antithesis of a framework

·       Tailored hedging product-suitability frameworks are often missing completely (premium illusion is real)

·       Tests for correlation (natural hedges), regular or otherwise, are typically missing

·       Stakeholder awareness is a problem (why did markets all rally 7% but we only made 3%?)

The last word

To leave you with a key message I’m going to turn to the words a professor of business history at Harvard Business School and Johns Hopkins University, Alfred D. Chandler Jr., who wrote that “unless structure follows strategy, inefficiency results”.

Mr Chandler’s theory is easy to quote, but what of the evidence it can work in investment management? As the Wall Street Journal recently found, Chandler’s approach has been found alive and well at a little-known US closed-end fund, Central Securities Corp, run by an even less well known manager: Wilmot H. Kidd III.

Wilmot H. Kidd III has racked up one of the greatest long-term track records in the history of investing.

Over the past 20 years, Mr. Kidd’s Central Securities Corp., a closed-end fund, has outperformed Warren Buffett’s Berkshire Hathaway Inc. Over the past 25, 30, 40 and even nearly 50 years under Mr. Kidd, Central Securities has resoundingly beaten the S&P 500.