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Speed traps

Last week, I indicated the increasing dominance of the stockmarket by investment professionals was behind the upsurge in share volatility. With hindsight, this appears a little oversimplistic. There have been other changes that add to the potential for wide swings in indices and the value attributed to individual companies.

Not least among these is the way in which technology has changed both the speed of reacting to events and the availability of more sophisticated investment products. Many of these products involve derivatives which are more complex due to technology input. With casualties of the sub-prime-induced credit crunch rising by the day, it is worth reflecting whether derivatives have helped or hindered.

In theory, derivatives deliver some degree of additional control to investment managers and other operators in financial markets but they also permit gearing that can add hugely to the risks involved. Moreover, derivatives’ trading has significantly increased the volatility in financial markets, with futures and options accounting for several times the value of trading in the cash market.

During the torrid conditions of the 1987 crash, the gap that opened up between the cash and derivatives markets led to the introduction of circuit-breakers to help control market volatility. Even so, from time to time, financial pundits, including the Sage of Omaha, Warren Buffett, have condemned derivatives as “weapons of financial mass destruction”.

The knowledge that a number of hedge funds have recently disappeared into financial obscurity will not have eased investors’ minds but the fact remains that derivatives are increasingly used in retail investment funds.There have been a number of launches of funds that appear to be a cross between a conventional long-only fund and a market-neutral hedge fund.

I am chairing a conference next week on the use of derivatives in fund management. Organised by Cofunds, it is one of a series aimed at taking themes in the retail fund industry and allowing management groups to explain how they approach an asset class or method of investing. It promises to be an interesting afternoon.

If the concentration of investment power into a small number of hands, speedier information distribution and securities trading through technology and the increasing use of derivatives in financial markets all combine to ensure that volatility is here to stay, what is the likely short-term direction of shares? Up and down, but not necessarily in that order seems the most likely outcome. The news flow appears capable of driving markets in both directions at speed. The risk appears to be a slowing of the global economy to the extent that support for equity markets is undermined. This is not a fanciful notion.

Aside from the spread of the US housing problem, which could drive down American economic growth, the apparent de-gearing of financial balance sheets worldwide could reduce liquidity and increase funding costs. which would impinge on economic activity.

This is why central banks are pumping cash into the system. There are rumours of a further cut in the Fed discount rate and by now it may already have taken place. Suggestions that large swathes of the German banking system are under water gained some currency recently. We have not heard the last of the credit crunch by any means.

Some riskier investment areas continue to hold up relatively well but will surely suffer if uncertainty persists. Investors should consider if illiquid, obscure and low-grade holdings still deserve a place in portfolios. Emerging markets look to be a potentially dangerous place as well. Troubled conditions are likely to remain for a while.

Brian Tora (brian.tora@centaur.co.uk) is principal of The Tora Partnership

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