Meditation on Risk and Return

Here's an issue about investment risk and return  that has been bugging me since a conversation with a guy who really should know better.

Start with the basics.  We take it for granted that investors do not like risk; that they will take risk if compensated, and compensation means  a higher rate of interest.  Oh, and for present purposes, interest=volatility.

So far, fine.  Now, consider AnnCo, the pension manager surveying its record over the past 10 years.  The risk-free rate is five percent; AnnCo took some risk and got eight percent.  Oh wait, AnnCo actually got eight percent per year "with notably rare exceptions," i.e., years seven, eight, nine and ten.  Did AnnCo do better than risk-free?   Obviously not.  Risk-free has accumulated $1.63 on a dollar over 10 years; AnnCo, just $1.59 (AnnCo's 10-year mean is 4.7 percent).

You knew that?  Course you did.  Grownups understand  it easily enough although it's surprising how ofen the point gets lost in discussion.   But try this.   PenCo  finds it averaged 7.75 percent over the last 20 years; therefore it thinks it is justified in using 7.75 as its estimate going forward.

Is this a fair analysis?  I think not.  Seems to me the real question is "what was the risk-free rate of return over the last 20 years."  One way to answer the question is to ask, "what kind of return would have have earned if you had bought Treasuries in 1991?"  The envelope, please--turns out that 10 year Treasuries were yielding over seven percent; 30s over eight.  So at 7.75 percent, PenCo isn't even beating risk-free.  Does anybody think the next 20 years will give us 7.75 percent risk-free?  Treasuries sure don't; Bloomberg tonight quotes 10s at 3.17 percent, 30s at 4.31 percent.  So for a 20, figure about half the 7.75 percent rate.

H/T again to Ignoto without whom this post would have been far more trivial and less interesting. 

The Private Equity Tsunami: A Dog that Isn't Barking

Josh Kosman's The Buyout of America isn't a great book but it is better than so-so.  As a history of private equity, it serves up a lot of edifying anecdote, albeit without much by way of disciplined evaluation.  The subtitle is designed to beguile you: "How Private Equity Will Cause the Next Great Credit Crisis."  The introduction serves up a hair-raising, if hypothetical, encounter between President Obama and his secretary of treasury, set for late 2011, in which the secretary explains to the President how private equity defaults are  driving the economy off a cliff.

Strictly speaking, we're not there yet, and who can tell what will happen in the remaining months.  But there is pretty good reason to believe that it simply isn't happening--that we will suffer nothing like the cascade of defaults that Kosman predicts, or at least not this year.

I don't count this as quite as big a blooper as it might seem: writers make this kind of mistake a lot and it really doesn't do much of anything to take away from the merits of the argument in general.  Moreover, I think Kosman probably had a reasonable basis for making his prediction when he did.  His problem: interest rates.  My guess is that he wasn't counting on anything like the near-universality of near-zero interest rates that appears to be our blessing and fate at least for the moment.  Low rates can be forgiving (sometimes too much so?) in the worst  of investment climates, and we can hardly be disappointed if, indeed, it turns out that he was wrong.  Meanwhile it appears the PE industry might have read his book: the business press reports a lot of restructuring of private equity loans, not least to head off precisely this sort of calamity.

He may address this issue in the paperback version which came out last November (the Kindle, which I read, appears to be based on the hardback).   I don't see anything about it at his personal website, but he does offer one beguiling freebie: a catalogue of "speculative grade" (heh!) credit facilities and bonds due through 2014.    The list  is a year old but it is free.  Moody's website offers an update, but it'll set you back $550.  Let's hope that Korman shares his copy again.