Investment Adventures in Emerging Markets

The Problem with the Misuse of Derivatives

I recently spoke at the Foreign Correspondents’ Club of Japan in Tokyo, where we covered a number of interesting topics. Following that event, you may have recently read headlines where the media has quoted me as predicting a second financial crisis. In this post, I’d like to give a little more context to that comment and also cover something I am particularly worried about: the problem of derivatives.

Market volatility is a reality of today and goes in two directions, up and down. One of the reasons we have (and are likely to continue to see) this level of volatility is because of the occasional misuse of derivatives. Of course, not all derivatives are bad. If understood and used appropriately they can be used by funds as tools to hedge or mitigate risk. For example, currency forwards or interest rate swaps are typically used to hedge out a fund’s risk related to a specific currency or interest rate exposure.

What I am most concerned about is the use of derivatives as speculative tools or derivatives that involve high levels of leverage where the investor did not adequately control the implied leverage and resulting market exposures and liabilities, such as companies that may use derivatives to “game” commodity exposures—a practice that generally makes it more difficult to accurately assess the value of a company’s stock. For example, an airline may start out using oil futures contracts to hedge the risk of a rise in the price of jet fuel, but may drift from this understandable hedging use into speculating on the price of oil—a potentially risky activity that is somewhat removed from its core business of air transport. Misusing these financial instruments contributed significantly to the global financial crisis in 2008, and they continue to be used today. The total value of derivatives in the world at the end of 2010 was more than $600 trillion. That’s 10 times the world’s total GDP.[1]  

When we have many derivative instruments betting in different directions with a lack of understanding and regulation, we are likely to have more volatility. Add to that the unforeseen and unpredictable events that occur across the world, together with an even more interconnected global marketplace, and we are likely to have more sharp and sudden moves in the market as knee-jerk reactions become more common among many investors. Such heightened volatility can scare people away from equity investments, which is a pity, since study after study has shown that in the long term, equities have outperformed.

We cannot exactly predict when the next market correction will hit us, nor know how great or small it will be, but we do realize that market volatility is here to stay. Few of the problems that caused the 2008 financial crisis have been resolved—banks are bigger than ever, and the derivatives market continues to grow and remains largely unregulated. It is heartening to see that international policymakers are trying to work toward a global regulatory standard, but until we find a true, long-term solution to these problems, we cannot ignore the possibility of another financial crisis.

But, as a long-standing English proverb tells us, we can “hope for the best and prepare for the worst.” With every crisis comes great opportunity. Therefore, we continue to invest with a long-term horizon in companies that we believe are undervalued, fundamentally strong and growing, and those that we think can weather through difficult times. Our long-term, ground-up, disciplined investing approach has kept us in good stead through the volatility so far and, I believe, could see us through potential crises or corrections that may loom around the corner.

[1]. Source: Bank of International Settlements, 18 May 2011.

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