October 21, 2014
Interviewed by: David Snow
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Why PE Will Benefit From a Low-Beta World

Author and journalist Sebastian Mallaby tells Privcap why private equity managers should benefit from the low-beta environment in the next few years, the future of the hedge fund industry, and why emerging market opportunities are not as plentiful as in past years.

Author and journalist Sebastian Mallaby tells Privcap why private equity managers should benefit from the low-beta environment in the next few years, the future of the hedge fund industry, and why emerging market opportunities are not as plentiful as in past years.

Why PE Will Benefit From a Low-Beta World
With Author and Journalist Sebastian Mallaby

David Snow, Privcap: Today, we’re joined by Sebastian Mallaby, an author and also the Paul A. Volcker Senior Fellow for International Economics at the Council on Foreign Relations. Sebastian, welcome to Privcap.  Thanks for coming by.

Sebastian Mallaby, The Council on Foreign Relations: Great to be with you.

Snow: You have a huge interest in the financial markets around the world, and in global economy. Let’s start with the fact that you are a chronicler of the history of financial markets and of the current lay of the land for financial markets. How did you come across financial markets as a topic that was worth pursuing as an author?

Mallaby: I began my career in journalism by joining The Economist magazine right out of university, and I went immediately to the place where there was the least finance of anywhere in the world, namely Africa. I lived in Zimbabwe, traveled around and used that as a base.

But I quickly figured out that if you want to understand Africa—if you want to understand the struggle to get out of poverty—you need to focus on the economics and the capital flows even if they are small in Africa. So, I became increasingly interested while I was there and when I came back to London to work for The Economist, I wanted to work in the finance section, so that’s what I did. I switched, made a big jump and it was a steep learning curve, but I would call out people in London, in the city and ask stupid questions like, “What’s a derivative?”

Snow: I don’t think we have enough time for me to learn what a derivative is, but we can move on to the subject of your most recent book, which is More Money Than God. It’s a chronicle of the rise of the hedge fund industry and the creation of a new elite based on hedge fund capital. What kind of a future do you predict for the hedge fund industry, now that we’ve had a couple of years, in general, of under-performance by those funds?

Mallaby: There were two main arguments for my bullishness about hedge funds in my book, which was published in 2010. The first was a kind of public policy argument. If you don’t like too-big-to-fail banks, then small-enough-to-fail hedge funds are a lot better for the system. If they fail, they don’t tend to be bailed out. Even long-term capital management receives zero dollars of taxpayer support.

There was also a private investor reason, which was that if you looked over time at hedge fund return and you stripped out the statistical biases that are real, survivorship bias and the data and all that stuff, you still found that net of fees, investors were getting a positive alpha of 3% a year. That’s data put together by Roger Ibbotson of Yale in a series of studies.

Now, you’re right that in the past couple of years people have been raising questions about the performance from hedge funds. In my view, those questions often completely miss the point. In other words, they are a straight comparison between what was the average hedge fund return on the one hand, and what was the S&P 500 on the other. That’s the wrong question to ask, because the whole point is that it’s not a vehicle for delivery beta. Beta investors can get, they should pay almost no money for it, a few basis points. You buy and ETF, you’re done. What’s interesting is how you add to that beta by putting in some alpha? For this, you will pay management fees, but if you gain alpha net of those fees, you will continue to do it. And the alpha remains positive.

Snow: Do you think hedge fund managers will continue to innovate in the ways they invest?

Mallaby: There are new ways of generating alpha, partly because markets are globalizing, so there are stock markets in East Asia, in Latin America and increasingly now in Africa, where you can begin to think of applying techniques that have worked in the U.S. to other places. So, globalization broadens the opportunity set for hedge funds.

The other thing is that new financial instruments are being invested all the time, and those require new types of arbitrage to extract inefficiencies and turn those into profits. So, unless you pause it that the world ceases to globalize, and that no financial innovation takes place anymore, there will always be new opportunities. And, because of the structure of hedge funds, the fact that investors have their own money in the fund, their own skin in the game, they’re going to manage risk well. Those new inefficiencies will be best discovered and extracted by hedge funds.

Snow: You must have views on the private equity industry, although you haven’t yet written a book about it. Where do you see private equity going in the next few years, now that we seem to be headed slowly out of the great recession? Do you see private equity continuing to grow as an asset class?

Mallaby: My general feeling about the next five years for investment is that we’re going to be a low beta environment for two reasons. The first is that trend growth, both in the rich world and in the emerging world, is going to be lower than it used to be. You can’t just ride the escalator of growth so easily. The second point is that quantitative easing has essentially brought forward tomorrow’s asset returns and jammed them into yesterday. We’ve had an enormous run-up in the S&P 500 because the central bankers have deliberately pushed people out of the risk curve. So, risk assets have been bid up, which means there’s less scope for upside in the next few years. And private equity companies that have a track record of deep industry expertise and an ability to implement management change and management improvement—these companies will be very valuable to investors who want to add alpha in a low beta environment.

Snow: What do you see as far as investment opportunities in the developing world and emerging markets? Should investors have their money there, or are they likely to be disappointed vis a vis the opportunities they could get in places like the U.S.?

Mallaby: There were two arguments underpinning investment in emerging markets. Once was that these emerging markets are going to grow super fast, so you should be in them. It’s true that they will continue to outperform the rich world in terms of growth rates, but that rate will come down. There have been a lot of tail winds that have helped emerging market growth, and those are gone. Very strong commodity prices—we’ve had that run up and it’s not going to go up any further.

Chinese demand was pushing a lot of exciting growth in other developing countries, but Chinese demand is going to moderate a bit, because growth rates have come down from a trend rate of 10% to around 7% now. There are these tail winds that used to be there. Another one is very cheap capital, and as we eventually exit quantitative easing when the Japanese and the Europeans are finally done with it, that tail wind will also go. So, the idea that you automatically get great returns needs a second look.

The second thing is that diversification was the big argument for going into emerging markets. If you have some U.S. equity and some European equity and some Japanese, should you just diversify it by going globally? True, but if you actually look at the constituent companies of the S&P 500, the companies themselves are diversified. They’ve gone global, so the investor is duplicating or doubling up on diversification, and I’m not sure how much additional benefit you’re getting these days by going out and buying emerging market stocks. You see that in the way that if you look at correlations in global equity markets, they’re way up compared to 10 or 15 years ago. I’m not against some emerging market investment, but I think the arguments are less strong than they used to be.

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