Davos 2011: How to Stop Worrying and Love the Risk
The global economy may be recovering, but the talk at the World Economic Forum in Davos is all about the risks: from currency wars to political turmoil, inequality, digital woes, and environmental problems.
It's a horror to most humans, they are risk-averse. But Davos Man sees the flipside of risk: a huge opportunity to make money.
So if you need a tip, here's the view from Davos on which investments are hot, and which are not.
It's based on the annual "investment heatmap", developed in a two-hour workshop; this year the organisers asked the participants how investors could thrive on risk.
The teams were told to work on four scenarios:
- increasing scarcity of energy, food and water
- disruptions of infrastructure and supply chains
- cyber risks, and
- exchange rate volatilities.
We had 20 minutes to discuss the opportunities buried in one of these risk scenarios, develop an investment strategy, and agree a sales pitch for our fund.
"$1bn doesn't get you very far these days," sniffed one of the participants, partner in a large private equity firm.
And indeed, what's a billion among friends.
When I asked the man in charge of a large investment fund how much money he was looking after, he was somewhat vague: "$106bn, or maybe $112bn… we're just doing our audit to make sure."
In round two of the game we had to pretend that we were a sovereign wealth fund, state-run investment funds that hoard money (usually coming from commodities) for a rainy day, or for the day the oil runs out.
Again we were given $1bn to invest, and by putting this money into either the best investment strategies developed in the first round or gold or US Treasury bonds, we voted for the best risk-based investment.
Scarcity of energy, food and water
Two teams worked on this problem, both identifying the same threats: agriculture and food production under pressure, water usage rising sharply but supply falling, energy demand soaring as consumers in developing nations are getting richer.
Their two strategies, however, were very different.
Team one, dubbed Aqua Vita, said it would invest in "enabling technologies" that would help people make better use of these resources.
Apart from taking a healthy cut for themselves, the mangers of the fund would also distribute some of the gains to local communities.
No such sentiment from team two and its Long-cycle Hedge Fund.
They proposed to invest 20% of the money in an active trading strategy, "trading in and out" of assets like commodities etc to ride the volatility of prices.
The rest would go into the United States, Canada and Australia, placing the money in at least 20 positions and betting "long-short" on "asymmetric outcomes" with little losses when the bet goes wrong, and huge gains should the bet pay off.
It sounds ruthless, but so was the audience. The hedge fund team was voted out of the competition, and Aqua Vita went into the next round.
Supply chain disruption
You may have heard of the "black swan" theory of economics, which says that investors and economists make a huge mistake when they ignore unusual outcomes… like the fact that there are not only white swans, but black ones as well.
The credit crunch of 2008 was such a black swan.
The first team called itself the White Swans, arguing that the "rare" and highly disruptive black swan events in reality are happening much more often than most people think.
They identified risks like government intervention, an increase in natural disasters, terrorism, the knock-on effects of an interconnected world.
Their proposal: an opportunistic, globally invested hedge fund, with no position larger than 5%, putting the money into long-dated cheap options that deliver in case something bad happens.
A third of the money would be reactive - invested based on events, and two-thirds pro-active, anticipating where disruptions might happen.
Fuel Your Life was their rival, which also identified social unrest and piracy around the Horn of Africa and the Chinese Sea as additional risks.
This team suggested a fairly conservative but dependable strategy, investing most of the money in a gas pipeline through the Baltic Sea that's already being built .
The pipeline's strength was its diversification of a highly risky supply chain through Belarus and the Ukraine, and the investment would generate annual returns of 10% over 30 years.
The first team narrowly won to go into the second round.
Exchange rate volatility
Developing countries can have a hard time finding investors, who worry about rapidly moving exchange rates and unhelpful banks.
But help is at hand, promised Exchange the World, a trading firm that would be the middleman for large currency transactions, hedging the exchange rate risk of companies while helping governments of poor countries to attract foreign direct investment.
The promised reward: a 20-40% return on equity.
That was not enough to beat the US Hyperinflation Fund, a team that was "micro-optimistic and macro-pessimistic".
The fund would "short" US interest rates, predicting them to rise sharply to around 10 or 15%, and go long on the dollar, expecting it to fall.
Yes, the fund was guaranteed to lose money for a while, but in case of a "catastrophic event", it could deliver a 500% return.
"You don't want it to happen," went the pitch, "but if it happens, you'll be glad to have it."
If betting on a horrible outcome upsets you, then think again.
Have you got car insurance? Maybe even life insurance for your partner? Are you losing a little bit of money every year (the premiums) but expect to get a big return should you wreck your car or your partner die?
Welcome to the club of people hedging their risk.
Only one team tackled this task but identified a wide range of potential problems before settling on three areas to invest in:
- Cloud computing
- Mobile workforces pose new security risks for companies.
Then there is the "insider threat" where a rogue staff member can open a company's systems to criminals or squirrel vital data away. No wonder that the team called itself "Wiki Who?"
And then there is the issue of business continuity, the need for redundant systems and energy back-ups in case a key component fails.
The team proposed to set up a venture capital fund that would put its money into young high-tech firms in Israel, Silicon Valley and the Boston area, to develop technologies that help companies to protect themselves against these risks.
Where did the money go?
With the seven teams having a total of $7bn in the pot, the big winner was team Aqua Viva and its sustainability concept, which attracted $2.1bn.
The hyperinflation team was runner-up … kind of.
It had attracted a lot of money, but one of the "sovereign wealth funds" shorted this fund, i.e. it bet that the fund's strategy would not work.
The seemingly clever move, however, triggered howls of derision when one fund manager pointed out that it would be much easier and cheaper to invest in US Treasury bills than go short on the currency volatility fund.
As a result, the hyperinflation team got $950m and tied for second place with… gold.
It was a controversial choice ("I never touch gold [as an investment]" said a few in the room), but an impassioned pitch by a gold bug in the room persuaded several teams to put some of their money into gold - although that might not be their personal choice.
Explaining their gold investment, one team leader said they had assumed that many sovereign wealth funds traditionally had invested in gold, and rightly or wrongly would probably do so again.
That left $800m each for the cyber risks fund and the supply chain investment.
And what about the once safest (and most boring) investment in the world, US government debt, the famous T-bills or Treasury bonds? One team put a measly $50m there, probably for old times' sake.
Because three years ago, during the same exercise, the winner by far was the team that pitched a "T-bills only" strategy.
Why was everybody so afraid of buying US government debt?
"We know that this year the US government has to sell $1,500bn of bonds. If we don't buy them, who is buying them, and at which price?" asked one investor.
"The US debt burden, both explicit and implicit," replied another fund manager, "now stands at $350,000 per head. Then you get a bit scary about your investment allocation."
It was not just the participants of this workshop who were left scratching their heads.
In several sessions earlier in the day, some participants had asked what would snap earlier: the US addiction to debt, or the patience of investors - especially China - who buy Treasury bonds?