Known unknowns

Given it was released close to two years ago, I am a bit late to the party in reading the latest book by Russell Napier, the economic historian and chairman of Mid Wynd (MWY). The book examines the Asian financial crisis which took place in the mid-1990s and the consequences of it.

It is difficult to synopsise all of the macro factors that contributed to the crisis in Asia but they include ‘hot’ money flowing into portfolio investments, as opposed to longer-term, more illiquid foreign direct investment. Currency pegs that led to commercial banks creating more money in order to keep rates at the same level as a depreciating dollar, which in turn fuelled speculative bubbles. Borrowing in foreign currencies that offered lower rates than the domestic currency, in the belief that currency pegs would remain stable.

One of the points Napier makes is that there is a kind of myopia that results in many fund managers failing to analyse asset classes or trends outside of their purview, particularly credit markets. He writes that until today “professional investors still operate largely in asset-class silos and crucial information that relates to the future does not flow between those silos”.

On one level it is hard to see how these things would not show up in equity analysis. For instance, if you are analysing a prospective addition to your portfolio, a company’s debt is always going to be part of that – as sell offs in REITs and other more rate-sensitive investments over the past two years show. You would also probably notice some of these trends in reverse. For instance, if a company’s value was inflated, you might work backwards and decide it was the result of more liquidity in the financial system.

However, there can be second-order effects which are much harder to predict. For example, you could have invested in a Thai company in the mid-90s with zero debt, but it would be very unlikely that it would not suffer from the wider economic malaise the country experienced in the second half of that decade. Similarly, if you have no currency hedge and there is an unpegging which leads to a negative turn in the exchange rate for the local currency your holdings are denominated in, the ‘quality’ of your investment is probably going to end up being of little consequence.

The trouble is that making these calls is a difficult thing to do. But that leaves us in the annoying position of knowing macro events pose a risk, but not necessarily when that risk will be realised or what form it might take.

Investment trust managers take different approaches to this problem. For instance, the managers at Ashoka India Equity (AIE) argue that assessing the impact of macro trends is close to impossible and that bottom-up analysis is ultimately what drives returns over the long-term. They do not ignore macro trends – India’s growing desire for consumer goods is clearly visible in the portfolio for instance – but this is secondary to ensuring companies have strong cash flows and management. The trust has delivered annualised share price returns, in GBP total return terms, in excess of 14%, so there may be some merit to their claims.

Other trusts, like Ruffer Investment Company (RICA), take a different approach. Manager Duncan MacInnes and his team take meaningful views on macro trends and structure the RICA portfolio accordingly. As a simple example of this, they have argued that inflation will remain higher on average over the coming decade and with greater volatility than in the past (so if it was flat at around 2% over the last decade, it may average 4% in the coming 10 years, but with years where it hits 10% and others where it’s 1%).

The RICA portfolio aims to grow investors’ capital but without suffering substantial drawdowns. We’ve seen this strategy work well over the past few years, with the fund performing well when the market crashed in early 2020 and then again as rate hikes and inflation came into play over the subsequent two years. The other positive here is that the managers acknowledge their macro calls could be wrong and structure the portfolio to minimise the drawdown that could ensue if that’s the case.

All of this essentially aligns with what the former US Secretary of Defence Donald Rumsfeld described “known unknowns”. Napier’s book is good at illustrating that there were many signs bad things would happen in Asian markets, but predicting exactly when they would occur or what the second-order effects would be was much more difficult. Investors will have to make up their own minds as to whether or not they believe the managers they invest with are prepared accordingly for any storm clouds on the horizon today.

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