Want High Returns? Take the Risks

Friday, April 30, 1999

Commentators have marveled how some of the best-managed banks in the United States and Europe, and the best minds on Wall Street, could have suffered such disastrous losses from investments in Asia, Russia, and elsewhere. These losses reveal not only that there are few free lunches available to investors but that it may be difficult even for the smartest to distinguish great opportunities from risky strategies.

The theory of efficient markets states that all known information is priced into equities, derivatives, and other securities, so that if some investments yield greater than normal returns, they also bear correspondingly greater risks. This is the best theory available for understanding the way assets are priced, but it is an imperfect one. There have been many exceptions, called “anomalies,” where investment strategies have for a while yielded exceptional returns without exceptional risk.

The simplest example of such an anomaly is when the price of the same stock is, say, higher in London than in New York, so that easy arbitrage profits can be made by buying shares in New York and selling them in London. But pure arbitrage opportunities are short lived.

The problem for investors is to distinguish truly excellent investment opportunities from strategies that yield high returns because of sizable underlying risks. This is often extremely difficult, especially when the risk is only a tiny probability of large losses. The losses would then be infrequent, but they would be whoppers when they occur.

I believe this explains why so many top banks and financial institutions were eager to invest large sums in Long-Term Capital Management, the hedge fund run by several of Wall Street’s savviest traders, including two who received the Nobel Prize for their pioneering contributions to the theory of option pricing. So much money was eagerly made available to this fund that the partners returned a couple of billion dollars because they felt there were not enough good investment opportunities.

The problem for investors is to distinguish truly excellent investment opportunities from strategies that yield high returns because of sizable underlying risks.

LTCM began in 1994, and the annual returns were extraordinary until the recent debacle: 43 percent on equity in 1995 and 41 percent in 1996. LTCM was secretive about its investment strategies, partly because it did not want them copied by others. So investors could not tell whether the remarkable performance was due to the discovery of a new way to take advantage of low-risk opportunities or whether it required taking risks on models of market behavior that might bring disaster.

The leading partners had always indicated to me that they were not simply involved in arbitrage and hedging activities and that their investments were partly based on imperfect models of determining interest rates and other prices. The remarkable performance of LTCM tended to turn aside concern about the size of the risk. So money poured in.

A similar situation explains the huge losses incurred by many banks and other financial institutions in Russia and other emerging markets. The payoffs were generally fantastic while the good times lasted. Here, too, investors could not easily tell whether they had discovered remarkably good opportunities where they could in effect “coin money” or whether they were exposing themselves to considerable risks.

There is now demand for greater regulatory oversight of hedge funds. But there is no reason to believe that regulators will have a greater ability to assess risks than the staff at banks such as UBS, which has written down its entire exposure to LTCM of more than $500 million.

It may be that bankers and other investors get careless after several excellent years of good results, as Treasury secretary Robert Rubin recently said in testimony before Congress. But is there much reason to believe that regulators, who are monitoring not their own but other people’s money, are immune to this optimism? Extensive regulation has not prevented European banks from taking a beating in Russia or American commercial banks, such as Citibank, from almost going bankrupt from disastrous Latin American loans in the 1980s.

No, greater regulation will not control greed and the eternal quest for investments that provide high returns with only modest risk. We can all become more immune to claims about great success, however, by assuming as a first approximation that markets are reasonably efficient, so that high returns typically carry sizable risk. For persons unwilling to bear heavy risk, this is likely to mean missing out on a few truly exceptional investments. But it also will enable investors to avoid the disasters now rocking many financial intermediaries.