JUNE 2010                                                                                                                                     Download PDF Version

Re-Thinking Risk

I recently received notification  of the closure of one of the most successful long-only funds I have ever invested in. The fund bought into the junior and intermediate oil and gas sector in Canada, has compounded by over 18% since it launched in 1991 and has returned in excess of 2,300% since inception. As Clarmond seeks to invest on behalf of clients in such exceptional funds it is always a sadness when such a trusted manager closes up shop.

Traditional Risk
At Clarmond we are currently conducting a review of our techniques and processes for risk management and this fund highlights a number of important issues.  The fund had a volatility as traditionally measured by standard deviation in excess of 30% and investors have been well rewarded for taking on this risk. However, the fund is also asset backed. That is to say that if the commodity prices fell (as happened regularly through cycles since 1991) the management of the underlying companies could cap their wells and wait; the investors therefore still owned the oil and gas in the ground. So how risky was this fund? As long as an investor had the luxury of time and could wait along with the companies’ management then maybe the traditional standard deviation overstated the risk.

The only time I ever saw the manager of this fund really at a loss was when the Canadian government suddenly would do something unexpected and often misguided which negatively affected sentiment and share prices.. The fund’s performance was suddenly no longer based on its traditional metrics and manager research but was at the mercy of politicians.

Politics, politics
We have written before about increase in political risk that we see entering the financial markets. The recent crises have led to an increase in government intervention which looks set to continue for years to come. Therefore the risk is that decisions will be based more on the opinion polls rather than on the longer-term health of the financial markets. Obama’s recent hammering of BP is a clear example of this. The oil spill is indisputably a terrible event, however, neither is it particularly edifying to see the President of the United States holding a metaphorical gun to BP’s head. Obama’s ratings are at their lowest point and the mid-term elections are getting closer. This is not a time to annoy the Obama, just ask General Stanley McChrystal.

The trouble is that the regulation of the financial system is a little more nuanced and subtle and may not mix with political electioneering. At Clarmond we put stop losses on accounts in advance of the G8 and G20 meetings (ironically in Canada) in case of a fiscal policy bust up. However, while keeping an eye on events in Canada and subsequent policy, we will endeavour to continue to manage the uncertainty on behalf of our clients and to spend time finding and researching funds to replace the one we have just lost.

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