Director's Comments

Acting on Faith: Investments 101 February, 2007 There are many frustrations in life, but one of the most frustrating ones for any adult is turning over to others responsibility for many major aspects of our lives. Doctors, plumbers, electricians… all provide important services for which each of us individually does not have the background or the talent for appraising the risks nor the benefits of certain actions. When hiring these individuals we are in fact often ‘Acting on Faith’ that they have the knowledge and self –interest to provide adequate service. Still we solder on, attempting to receive the best available information before acting with the full realization that we are never working with full information. It therefore came a little surprise that a recent ‘Special Report: Risk Management entitled “Acting on Faith” in the February 5, 2007 Issue of Pension and Investment Age” expressed the fear that institutional investors were leaping into the realm of alternative investments but lack the tools to properly assess the risks. No I am not recommending that uninformed unknowledgeable individuals or investors immediately invest in areas in which they have no understandings of the risks and expected returns. It was surprising to me that that the author was implying that most investors (especially institutional investors) are clueless about the potential risks in alternative investments. Quickly let us remind investors, that it is impossible to obtained abnormal returns without abnormal risks and normal returns without normal risk. Without risk one merely obtains the risk free return. Fortunately, in those cases where abnormal return without risk does exist, there also exists enough talented individuals who will use their knowledge and resources to investigate and manage those risks for us, taking a fee to cover their costs and their return on knowledge while leaving for us the opportunity of investing in an asset which offers returns (and risk) not found in other investment opportunities. These experts exist in most areas of finance including traditional investments: I rely on equity analysis to decipher when GM is spinning off a unit. I require a bond analyst for determining the exchange rate policy of Singapore. Now do any of us really believe that we can truly quantify the risks that the stock or bond analyst may be wrong? No for many of us we have some historical knowledge as to the probability (risk) of investing in a particular asset as well as a feeling for the uncertainty (lack of a full model of risk estimation) surrounding any investment. In fact, it is the very dynamic quality and thus the existence of investor uncertainty as to the potential risks and returns that provides the informational asymmetry (analyst has more knowledge than many other investors) that gives alternative asset managers the opportunity of using their skills and resources to obtain higher potential returns than many traditional assets. Are there risks and uncertainties? Yes. Are their uncertainties? Yes. Can they be managed? Yes. Can they be overemphasized? YES. In a Weekend interview with Myron Scholes published in the Sunday Wall Street Journal (March 4, 2007), the Nobel laureate says learning can be costly. Scholes states that “In life you pay tuition, right? Sometimes you pay too much tuition. Sometimes learning is costly” In summary he points out that “in life, it would be kind of boring if there was no risk. On the other hand, if there‘s too much risk, too much uncertainty, too much chaos, we can’t handle it either.” The question in the article “Acting on Faith” is that the author emphasizes that much of current investing in alternatives is based on ‘Too Much Faith’. This is where the academic in me comes in as well as the investor. I am happy with the article because, if, in fact, there are as many uneducated institutional investors as indicated in the article, I will have the alternative area much to myself for the foreseeable future and I can make a lot of money investing and educating. More individuals will take my class, more individuals will take the CAIA program, and excess returns will remain in the various investment classes. I do not have the time or the space for pointing out all the issues have I have with the article in Pension and Investments. Please merely go to the CISDM website and review the Myths of Hedge funds. Quickly, here are a few: Most Alternative investment strategies are illiquid: Yes some but not most. Most trade in very liquid equity and bond markets as well as liquid futures and options markets. Return Distributions are unknown, skewed, and conditional on market events. Yes, risk and return is conditional on information. In certain market all assets fall, in certain markets all assets rise, in most markets some rise and some fall (on the date of the 400 point drop in the DJ, The DJ convertible arbitrage, merger arbitrage and other HF strategies made money). Investor must keep educated. For example the oft quoted HF are negatively skewed is due to a historical data points and for much of our history, hedge funds returns are positively skewed. Leverage: Academic research has shown that for many alternative investments leverage is not related to risk; that is, leverage exists primarily in the least risky assets (EMN) and not in the most risky (Distressed Debt). By the way what is your most levered asset (probably your own house). Style Drift: Yes strategies change this is good. You do not want a strategy to remain fixed in the past providing no return and not taking advantage of new opportunities. That’s where the return is. Simply be aware of what the strategy is and how it is changing. (remember today’s GM is not yesterday’s GM and it should even have changed more) Data worries: For most hedge fund managers prices are available daily, and through third party administrators. Benchmarks are increasingly available including daily hedge fund, real estate, and private equity benchmarks. The fact that we do not have 80 years of data as on stocks and bonds is a big so what –what happened in markets 20 or 30 years ago is of little relevance today. Transparency: Does any one really know what is going on in GM. In fact there is more transparency in many real estate, private equity, and hedge fund process that in equity or bond markets with the almost impossible to read debentures I am always amazed at my students who want a world that is safe and secure and perfectly knowable. I point out that if the world was easy and risk less their one could hire a monkey and feed it bananas. I understand those who don’t have the time, the will or the background to move into new areas of business, new areas of investment. I thank the heavens for them; it offers all those who are willing to remain “on top of things’ to move ahead with new risks and new opportunities. Will you always win? No, life has a lot of risk, a lot of uncertainty… and for those willing to spend a little of their time to reduce that risk and uncertainty ………a lot of return.

Thomas Schneeweis
Director/CISDM