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Keynote Speech
Solving the Long Term
Investment EquationMilan, June 25th 2012
Fabio ScacciavillaniChief Economist, OIF
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Millennial View
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Western
Europe FSU
United
States Japan China India
1500 17.9% 3.4% 0.3% 3.1% 25.0% 24.5%
1600 20.0 3.5 0.2 2.9 29.1 22.5
1700 22.5 4.4 0.1 4.1 22.3 24.4
1820 23.6 5.4 1.8 3.0 32.9 16.0
1870 33.6 7.6 8.9 2.3 17.2 12.2
1913 33.5 8.6 19.1 2.6 8.9 7.6
1950 26.3 9.6 27.3 3.0 4.5 4.1
1973 25.7 9.4 22.0 7.7 4.6 3.1
1998 20.6 3.4 21.9 7.6 11.5 5.0
2006e 19.0 3.8 19.7 6.3 15.1 6.3
Source: Angus Maddison, The World Economy: A Millennial Perspective, OECD (2001);IMF; Morgan Stanley Research
Contribution to global GDP in the last 6 centuries at 1990 International (PPP) US$
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Shift in Barycenter
4Source: World Bank Global Development Horizons 2011Note: Shares are expressed in real 2005 US dollars
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Economic Barycenter
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Gompertz curve
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Macrowaves
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The Century of the Dragon
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Asset Allocation
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Mac World vs Tata & HTC
Mature economies retain some advantages
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How The Extras Became
Protagonists
Most Western countries have been living above their means, thanks to mounting privateliabilities in the US, UK, Spain and public liabilities in Continental Europe
This came as a result of an attempt to counter the loss of technological edge and ademographic decline
Public opinion and leaders in developed world are still in denial
Cuts to discretionary spending, marginal entitlement trimmings and cuts in publicinvestments are mere palliatives
It is required a re-engineering of the fundamental functions of the public sector and itsfinancing starting from the educational system
l d li d
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Secular decline treatedas cyclical problem
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Aftermath
The world will deal with the
aftermath of this crisis for several
years.
The illusion of quickly reverting tothe days of easy money and
growing stock indices thanks to
injections of money are giving
way to the awareness that theadjustment will be painful
Some call it the New Normal
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Financial Barycenter
The hubs and spikes model of global financialmarkets is inadequate for a multipolar worldand implies a dangerous concentration of
systemic risks Pinnacles: London and New York
Cobweb model is the most natural alternative
South-South relationships need to strengthenand find alternatives linkages
Towards a multi-currency regime
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State Capitalism?
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The crisis of Western liberal
capitalism has coincided with the rise
of a powerful new form of state
capitalism in emerging markets
The crisis of liberal capitalism has
been rendered more serious by the
rise of a potent alternative: state
capitalism which tries to meld thepowers of the state with the powers
of capitalism.
Source : Special Report on State Capitalism
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SWFs: Public vs Private
Historically, the demarcation between public and private sphere in the economy swingslike an irregular pendulum in response to circumstances and political mood.
Financial markets were widely viewed as a preserve of individuals, firms and privateinstitutions
Any interference by a publicly owned entity was deemed an undue interference at oddwith well-established laws, norms and practices.
The massive bail out of key international banks and industries like car manufacturingshattered this sanctimonious attitude.
KfW, EDF, ENI, Fannie & Freddie, Landesbanken etc.
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The role of SWFs
The surge in capital flows that we have witnessed overthe last 25 years is the fundamental propeller of this re-balancing because it transformed the sign of thedemographic variable in the equation of economicdevelopment
Qatar vs Russia
The expanding role of SWF reflects this secular inversionin the distribution of global wealth from mature
economies, primarily the United States and Europe, tocountries such as China, India and Brazil which enjoyfavourable demographics, and to those with sizablenatural resources such as the UAE, Norway, Australia andRussia.
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Capitalism is Risk
Growth, progress, new ventures, technological advances and implementation of newdiscoveries are subject to uncertainty
Risk will materialize no matter how many precautions one adopts, so a capitalistsystem is inherently subject to instability, cycles, crises and disruptions.
This does not imply that capitalismis wrong. It implies that riskmanagement is atthe core of capitalism and the cornerstone of free markets.
Widespread ineptitude in risk management is more dangerous for free markets thanany collectivist ideology.
Incompetent bankers can obliterate free markets. Communists cant.
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When the Crisis Struck
To the majority of practitioners, and almost allregulators, the quasi-meltdown of the
financial markets in the autumn of 2008 cameas a shock
They were genuinely convinced that theywere relying on state-of-the-art models whichwould capture accurately the exposure to riskand provide early signals of impending
mayhem. 19
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Illusion
They were genuinely convinced that fancyformulas and complex numerical solutions topartial differential equations were an accuratedescription of reality.
They were genuinely convinced that they hadreliably estimated, within a narrow confidenceinterval, stable correlations between assetprices, including those of derivatives contracts
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H d i
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Hedging
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Everybodythinks he will
be smarterthan the restand be able
to reach foran exit beforethe others
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Financial fragility
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Unsteady
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Unsteady
Unregulated Markets
1. Asymmetric rewards for success andfailure
2. Marked tendency to herd behavior
3. Ineptitude to monitor at the same timeall sources of risk,
4. Over-reliance on short memory and
recent experience5. Absence of checks and balances in
decision making
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The strategies of most
SWFs or FWFs display a
higher risk tolerance onlonger term investments,
with far reaching
implications for their riskmanagement.
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SWFs were caught off guard
Many SWFs were run with a degree of sophistication morereminiscent of small family offices rather than leadingfinancial institutions.
They were misled by the microeconomic picture depicted inthe financial analysis of (often unreliable) balance sheetswhich conflicted with the macroeconomic clouds on thehorizon.
Worse, the microeconomic analysis was distorted byaccounting smoke and mirrors that concealed the banksleverage, built through a shadow banking system and theimbalances between short term liabilities and long-termrisky assets that beset Bear Sterns and Lehman and manyother large financial institutions.
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Risk Management
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We mustlook at
riskunder anew light
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F k K i h
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Frank Knight
Risk refers to an event whose occurrence
is governed by a probability law and can
be insured against
Uncertainty, refers to an event whose
probability is unknown because, for
example, it is rare (earthquake followed
by tsunami), or it never occurred in the
past (9/11) or because its consequences
are unimaginable (the Lehman default or
an asteroid hitting a large urban area)
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Mandelbrot
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Mandelbrot: even the mostadvanced quantitative methods donot capture the complexity ofphenomena we classify as RISK
Tail Events
Black SwansPersistence
Non Gaussian
Risk Management or
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Risk Management orRain Dance?
The complexity of what we colloquially call risk is extremely varied and, despiteconsiderable research, still poorly understood. Current mathematical knowledge
does not allow measuring the tangle of interactions which give rise to risk.
Financial professionals, at least until the Lehman bankruptcy, believed that risk
was, by and large, measurable via statistical analyses performed on a set of data.
This faith was strengthened by the development of what seemed ever more
sophisticated econometric techniques and asset pricing models. The availability
of massive financial time series on which to test these models seemed to add
soundness to what turned out to be essentially more sophisticated rain dances.
Models are useful in conceptualizing and summarizing intricate phenomena, but
the maze of interrelations among agents, their expectations, their information,
their strategic behaviour and the effect of policy actions escape quantification
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Turn off the Autopilot
Risk management is human judgment guided by a set of
imperfect quantitative tools and constantly updated
qualitative assessment. Quantitative tools must not be
considered an auto-pilot system
Asset valuations are probability distributions, not exact
calculations
These probability distributions will always be influenced
by the business cycle, which remains the fundamental
driver of market and systemic risk.
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M i
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Macroeconomics
Forming expectations on the macroeconomicoutlook is critical but not enough, because the linkbetween macroeconomic fluctuations and assetprices is inherently unstable
Models that aim to estimate the parameters of sucha relationship are not reliable, nor are models thatrely on past data to estimate a probabilitydistribution of returns and correlations
Sloppy currency risk management is financialsuicide in a multi-polar world. FX is a fundamentaldriver of performance
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A h
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Top Down Approach
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SWF A Cl
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SWFs as an Asset Class
SWFs rarely face sudden redemptions, hence they donot need to be over-concerned about liquidity risk orcrippling margin calls.
Stable endowment and long-term focus do not imply
complacency on risk management or careless riskassessment.
It means that they need to assign a different set ofweights to various sources of risks than mainstream
asset managers. But the risk management for long term investing is
completely different from the mainstream concept.
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Financial returnsdiversification
vs
Growth driversdiversifications
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Long Run Growth Drivers and
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Long Run Growth Drivers and
Implications for Risk Management
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What drives long term growth? => Investment Themesrather than asset classes in order to diversify risk.
Demographics & Education
Infrastructure & Urbanization
Natural Resources Supercycle
Technological Advances
Logistics and integration of value chains
Fluidification of Business Environment
The Six Killer Applications (Niall Ferguson)
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Six Killer Applications
Political and economic competition
Rule of law
Scientific revolution
Modern medicine
Education
The work ethic
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Institutional
Capital
Human
Capital
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Hi-Tech
The most difficult strategies for risk managementare those that pursue technological advances.Here the only meaningful approach is a
diversification into several projects.
Betting on new technologies requires a hugetolerance for failure, because in the bestcircumstances only half of the projects survive andeven fewer thrive.
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Di d i h di
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Diamond in the dirt
At the far end of the risk spectrum are investmentsthat aim to take advantage of a return to normalcy inwar-stricken countries. This driver is largelyindependent of global macroeconomic conditions,but needless to say, the success of investments inplaces like Iraq or Ivory Coast is a bet that spans atleast 510 years.
Few dare to invest in such places but to skeptics it
suffices to mention that Lebanon has been one of thebest performing economies throughout the GreatRecession and that the Iraqi stock market was astellar performer in 20102011.
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Concluding Remarks
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Concluding Remarks
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Risk management hinging on financial time series is misleading
Many prescriptions to manage risk which might be sensible at
microeconomic levelMarkets sometimes do not work properly: if they were therewould be no need for prudential supervision
Insisting on market mechanisms to solve problem arising fromdysfunctional markets is a recipe for disaster
Long term risk management needs to focus on long term driversof growth.
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Thank YouOman Investment Fund (OIF)
P. O. Box 329, P.C. 115Sultanate of Oman
T: +968-2464 3035
M: +968-9321 4978
F: +968-2469 1344
W: http://www.oif.om
mailto:[email protected]://www.oif.om/http://www.oif.om/mailto:[email protected]