Alternative investment funds: the new power broker?

The recent report by McKinsey has identified new financial markets participants, which might unexpectedly affect its development. Petrodollars, Asian center banks, hedge and private equity funds – these institutions, as the report mentions, have obtained a great ability to influence financial markets during the last 6 years. Besides, even under optimistic assumptions, in the same period ahead, the new power brokers might reach the size when other investment funds will have to adopt their behavior according to the new brokers’ actions.

On the other hand, one might imagine that development of financial markets won’t end with that. Due to the effect of financial innovations spiral, the market will not only face the increased amount of current instruments sold, but also will be pumped with fresh derivatives, funds, or even organizations. It is also possible, that the market will notice several new brokers until 2012, similarly as it did during the last 6 years. Moreover, it might appear later that even petrodollars, private equity, or something else will only enjoy runner-up’s role in financial decision making. But what can lead to that? To answer this question, I will try to analyze the reasons of the new brokers’ fast growth and briefly evaluate corresponding risks. Next, I will let myself image what can be an alternative to the new brokers in future, demonstrating its present drivers. Finally, I will think of potential development of both new investment types and the whole world financial market.

Where do the new power brokers come from?

Petrodollars. Amount of assets, purchased for petrodollars are increasing rapidly, similarly as oil price is. The price of crude oil (WTI) has been rising by 17.35% annually since 2000, which in total results in 241.45% growth by October 17, 2007, when this article was born in mind. During the same time oil assets has been growing by 19% annually (McKinsey Global Institute: New Power Brokers ), which makes it the most fast growing investor in the world. There are several distinguished reasons which make oil prices so drastic. Firstly, it is booming demand for oil coming from developing regions, such as India and China. Next, it is the effect of decreasing oil recovery, and what is most important, it is depreciating US dollar which together move prices up. Nevertheless, we must agree that in 2002 majority of the market players didn’t expect such a dramatic development of the commodity cost. The support of the statement is depicted on the graph, which clearly demonstrates the uptrend emerging in the middle of 2003. Surprisingly, the forecast of Western Governor’s Association conducted in 2002, expected today’s oil price to reach the boundary of 30$ per barrel. Ironically, this was not an exceptional estimation of the time.

Hence, oil market, as financial is, can be overwhelmed with both right and not always right predictions. Oil price boom has become so unexpectedly huge which almost equalised the impact of petrodollars on world finance with the impact of insurance companies, pension or mutual funds. Moreover, due to the lack of regulatory legislation, size of the impact might broaden surprisingly in the future, as oil prices did in 2004. At least, several investment funds start believing in such pessimistic scenario.

Though, let’s look on correlation coefficient between US dollar rate and oil price, which in my opinion is the main indicator in oil market analysis. Starting from 2000 until October 17, 2007, correlation coefficient between the two nominal values is roughly 81%. This situation is depicted on the graph which demonstrates the relationship between the values. It is clearly visible that when US dollar depreciates against Euro, and thus against other world currencies, the price of oil increases. As a result, if the government of the USA maintains its secure currency rate, oil prices are also likely to decrease or at least become more stable. I will discuss neither benefits nor drawbacks of the potential policy for the country, but will only assume the US dollar rate to be less fluctuating in the future. My assumption is supported by the fact that dollars demand won’t decrease dramatically to affect world economy and commodity prices: it will stay the main foreign reserves currency; T-notes and T-bonds will continue to be the most popular long term instruments among institutional investors; major financial assets and commodities traded on world exchanges will be quoted in American dollars. In total, the probability of US dollar to depreciate by half during the next 6 years is likely to be low. Consequently, oil price will also behave less aggressively in the future that will diminish the influence of petrodollars on financial markets, even under no severe regulatory legislation.


Asian center banks. To analyze this category of the new brokers I will use the data from Chinese foreign exchange reserves, since it accounts for 30% of the total Asian center banks reserves and takes the first place by its size in the region. According to the latest available data, foreign reserves of China reached the value of 1.2 trillion dollars in March 2007. Foreign exchange reserves of India, Malaysia, Singapore, South Korea and other Asian countries were rising with the same pace. According to the forecast of a moving average, which is depicted on the graph, the foreign exchange reserves of China will reach the point of 1.4 trillion dollars, all other things held constant. Moreover, McKinsey expect the total number of the reserves to reach 5.1 trillion US dollars by 2012, given annual investments of 321 billions.

On the other hand, actually the potential threat of that investor might be less significant in future than it is being discussed today. For example, the initiative of G7 suggests IMF to develop the proper codes of conduct for state-owned investment funds to reduce the influence of Asian center banks on international financial markets. The codes will promote the strategy of investment based on efficient allocation of resources. If G7 manages to prove the legitimacy and value of the document to the target broker, the investments of Asian center banks will become more transparent and understandable that will make their effect on world financial markets lesser. Moreover, if take into account the membership of Japan in G7, the country which in fact represents Asia in the institution, major benefits of the codes in the region might only increase. Next, we should also notice that Japan is included in the report of McKinsey as the second biggest holder of foreign exchange reserves after China with 25% part of the broker’s category. Since it is at least unreasonable to expect Japan breaking world economies and manipulating financial markets, together with other mentioned arguments, I imply that the potential influence this broker is probably overvalued.

Hedge funds. According to the general practice, hedge funds usually outperform both mutual and index funds, even net of management fees. The following graph depicts the comparison between two different hedge funds strategies and the world composite stock index. The picture is clear: hedge funds were earning rents when world market was not only rising, but when declining either. Moreover, the correlation coefficient between the returns of the graph hedge funds and that of the world index is not more that 50%, which implies significant achievements in unique risk diversification. Unfortunately, this is a problem for mutual funds managers, since they are unable to create new financial instruments and use the variety of hedging strategies which is prohibited for them but is legal for hedge funds. There is a certain opinion, that mainly privacy of hedge funds results in their huge positive returns. Really, if the fund is successful to find a heavily undervalued company, what are the reasons it must inform regulatory authorities and, hence, the whole world about its potential investments. Furthermore, according to Ben Bernanke, hedge funds should not be regulated directly, but controlled ultimately with the help of brokers, when no intervention in free market relations appears. To that statement one can emphasize the weight of brokers and hedge funds independence. Moreover, I suggest you to remember one exciting fact, when representatives of the Deutsche Bank widely offered to other commercial banks to open doors and windows in their houses and demonstrate the truth about the whole business. Does it mean that the tightest regulations of commercial banks doesn’t produce positive outcomes in reality, or is it a subject of law detour? Probably, this question will stay with no answer, but to conclude, hedge funds wont’ benefit from “fake” regulations in either case.

Next, one would claim that even leveraged trading is not the biggest problem of today’s hedge funds. Unlikely, LTCM story will be repeated in the future, since both funds and their creditors become more attentive to credit risks. Otherwise, why do creditors trust hedge funds to use 500% leverage unless they expect full repayments. It might be caused by high reputation and stable growth of the funds. Additionally, in case of some fund’s default, creditors might expect other market players to take the responsibility of loser’s debt settlement, as it happened with LTCM. Given that hedge funds have still been using leverage since the scandal, probably such operating scheme, when every fund is implicitly supported by others, satisfies not only fund managers, but also their creditors. Then, it seems more profitable for hedge funds to share the common credit risk of the brokers’ category than completely give up their business. Consequently, with the help of such regeneration mechanism the group assets might grow dramatically. However, if the market practically is not harmed by the growth and investors gain enormous excess returns, why not to allow the development of hedge funds? In the end, I conclude that negative influence of the group on world financial market might also be equally overvalued.

Private equity funds. In total, private equity funds is a relatively small segment of financial market, which accounts, according to McKinsey, only for 1.1% of the total investment capital. Also, according to the company’s estimations, the part of private equity will reach the level of 1.3% of total world investments by 2012, which proves to be a tiny value comparing with giants like pension funds or insurance companies. Steve Kaplan and Antoinette Scholar demonstrated that during the period of 1991-2000 private equity was growing by 34% annually on average, from 10 to 180 billion US dollars. According to McKinsey, the funds value increased up to 700 billion dollars in 2006, resulting in 25% average annualized growth. By 2012, the point of 1.4 trillion dollars will be touched with only 12% average annual increase in hedge funds value. These numbers mean that the growth rate of funds’ value is constantly decreasing. Keeping in mind the little size of the whole group, the pressure of private equity funds on world financial markets perhaps is overvalued. Moreover, the market of private equity is confirmed to be cyclical (Kaplan & Schoar, 2004, “Return., Persistence and Capital Flows”). Hence, the current behavior of the markets to high extent reminds the declining wave of private equity activity rather than its explosion. Nevertheless, to completely be sure about the lack of problems, which private equity is being claimed to cause, one should soberly evaluate their potential threats.

Mainly private equity funds are criticized since they apparently take companies over to receive or resell their valuable assets. However, as a counterargument to the first statement, one might notice that financial markets price reputation of their participants extremely high. Not without a reason, hostile takeovers, especially with further company’s liquidation, create huge negative feedback from both other market players and society in general. Unlike hedge funds, activity of private equity funds is evident and clear, meaning their future conditions primarily depend on their recent strategies. If the market is disappointed with certain activities of one participant, most probably it will neglect such unethical player in future, or will create pressure on him to quit.

Conclusions on four power brokers

All in all, I conclude that risks of the new power brokers, as they were labeled by McKinsey, perhaps might be overestimated. Major dangers of these investors on world financial market can either be eliminated or they are simply small by definition. First of all, the real oil price is relatively stable and have been stable for long time due to it correlation with US dollar rate. Consequently, the real value of assets purchased for petrodollars has changed insignificantly during the latest 6 years. Second of all, international pressure on Asian center banks with considerable help of Japan can relatively easy limit their negative impact on world financial markets. Third of all, hedge funds – the next market threat – have been outperforming world index for the last 6 years, showing results better than other mutual and index funds. Furthermore, while world markets were hopelessly falling, hedge funds earned positive profit. Finally, private equity funds are simply so small comparing with other part of world investments that even neglecting the fact of bad reputation their influence on the market won’t be seriously large.

Further financial market’s development perspectives

So what can substitute the above mentioned brokers, if they won’t reach their severe potential threats, as it is being discussed today? Probably, those investors, who are not so attractive today, reminding the McKinsey brokers in 2000, can actually become key market players in the nearest future.

For example, ethical funds (also known as social or green funds) might correspond to set requirements. Also, McKinsey brokers might be called ethical if they reduce the scope of their potential investments. Moreover, the same practice applies to mutual funds, investment companies and even individual investors. In total, according to some supported expectations, future investment decisions won’t mainly be based on financial performance and risks of companies, but on their view on corporate responsibility and amount of pollution caused by their activity. An interesting fact, during the period of January 2000 – July 2006 the value of assets managed by European ethical funds rose more than 3 times, resulting in 23% annualized growth rate, keeping in mind that the number of funds had only doubled. During the same time, the number of mutual funds increased 1.7 times. To evaluate the probability of high ethical funds attractiveness I will further present several major factors, which might drastically influence the development of world financial markets.

Drivers of ethical funds growth

Theory. The idea of ethical investment, discussed by Robert Heinkel et al. (Robert Heinkel, Alan Kraus, and Josef Zechner, Journal of Finance and Quantitative Analysis Vol.36 No.4, 2001, “The Effect of Green Investment on Corporate Behaviour”), is based on the fact that polluting (and irresponsible) companies have less shareholders than similar but non-polluting companies, since green investors do not put their money in unethical firms. Consequently, the risk of such companies is distributed among smaller number of investors, who require privileged compensations. This increases the cost of company’s capital and makes it harder to attract new resources, thus affects future strategy. Until the costs of lost investments are lower than reorganization costs, companies will continue its current operations with no concern about social responsibility or pollution. However, in the long run this might not work. Thus, companies will have only to reorganize if ethical investors have enough assets to force them to do that, or in other words if indifferent investors will have less assets. The third interpretation, reorganization rate depends on how many investors will transform their money from socially independent funds to those who promote corporate citizenship, social responsibility and green investments. If the amount of social funds rises than their influence actually becomes more serious than, say, that of private equity funds. Also, in particular case of green funds, companies should not only care about their corporate governance issues, but also devote time to reduce negative impact on environment. Of course, there might be insignificant relationships between outlined market players today, but who was caring about petrodollars in early century? If growth rate of ethical funds assets will stay constant, we should expect about 120 billion US dollars under their management by 2012, which is a tenth part of the private equity investments.


Practice. In reality it seems quite probable that ethical funds growth rate won’t decrease in future, but vice a versa will gain extra pace, which might result from the following reasons. Firstly, the average return rate of ethical funds is quite high and less volatile than, for instance, S&P500 index. Even if one compares the average growth rate of European ethical funds with one of the most successful and large US mutual funds, Mairs&Power Growth Fund, ethical funds lose relatively little and sometimes even outperform elite indices. Secondly, social and ethical funds were less reactive on the latest real estate sub-prime crisis and showed better results than other mutual funds. While in October 2006 Fitch, Moody’s and S&P were ranking sub-prime market as quite safe, ethical funds closed their positions in the market, expecting its correction. Thirdly, today the global heating problems together with other ecological issues are quite passionately discussed on political, social and economical high-level meeting across the world. For example, a well known politician, Albert Gore, have recently been awarded the Nobel price in Peace for his study of human activity influence on the environment and climate change. This is only one of the variety of examples, which particularly means that social attention to the problem is rising extremely quickly. It is not vital for Gore’s and similar theories to be right, but they start shaping financial markets already at present, which is going to make sufficient pressure on dirty companies and grant ethical and green funds with wider opportunities and appreciation. Fourthly, such funds do not require strong additional monitoring and regulation. Partly because, this is their responsibility to create investment rules on the market, according to which companies and other investment funds will sooner or later be forced to act. Also, they are already operating under control as a specific group of mutual funds. Consequently, there are no rational reasons for this category of investors to stagnate, since ethical funds meet the interests of financial and social worlds more than any other kind of brokers, even the power brokers.

Conclusions

Actually, while evaluating the risks of such investors as Asian center banks, petrodollars assets, hedge funds and private equity funds some major aspects were ignored, similarly as other were emotionally overvalued. McKinsey, in fact, didn’t present new facts about world financial markets in its reports, but collected public opinions about specific investors. Sometimes, when society is arguing about potential threats of 4 power brokers, it skips the second part of the pie, which was also noticed in the report of the consulting company. On the hand, it might be true that the new power brokers will take part in market control to some extent. On the other hand, I personally do not agree with such viewpoint and thus have tried to demonstrate which hidden variables can make the market to act according to new rules.

The main variable, according to this article, is the impact of ethical, green and social funds. Next, I have presented several arguments proving that primarily these organizations will be coordinating financial routes in the future. Simply, decisions of green investors will affect the development of hedge funds, private equity and other investment funds. Probably, some of the mentioned funds can also reposition themselves as green or social to attract more investors. Besides, the great advantage for McKinsey brokers to choose social investment strategies is that ethically behaving funds are less criticized by society and have a greater variety of investment potential. Who knows, but maybe they will also be justified for leverage and short sales if, say, it will be used to invest in socially responsible or ecologically active companies? If so, starting from now, we should take a glance on ethical investors.