Portfolio & Risk Management for Central Banks and Sovereign Wealth Funds

My Chapter on “Portfolio & Risk Management for Central Banks and Sovereign Wealth Funds” published by Palgrave Macmillan ——

Attached my piece published by Palgrave Macmillan in a book as part of proceedings of the World Bank, Bank for International Settlements, European Central Bank Public Investors Conference.

This will be of interest to those seeking original readings on Reserves Management for central banks and sovereign wealth funds. It aims to outline best practice in respect of strategic asset allocation, facilitating knowledge-sharing across organizations and encouraging collaboration and dialogue between reserves and asset management specialists.

Hidden Risks in Credit Investing

Summary

Many investors, especially retail investors, often remain unaware of the real risks in credit investing. This note highlights the pitfalls of ignoring the low-probability costly events of default while integrating credit risky assets into portfolios. The shape of the risk profile of a credit portfolio is affected substantially by the tails caused by rare credit events. To efficiently tradeoff long-term expected return with risks, we must recognize that the risks are in the tails. It is important that extreme but exceedingly rare credit events be properly simulated with sufficient accuracy. Furthermore, a risk metric must be chosen that accurately captures the impact of the tails. Conditional value-at-risk is one such metric. Its use ensures that long-term investing goals can be met, without suffering catastrophic blows from the tails in the short run. The models for limiting tail effects should also be applicable to portfolios of assets with correlated defaults, such as collateralized loan or debt obligations.

Introduction

Credit risky securities and most of their derivatives are characterized by a large chance of positive returns (periodic coupons) and an exceedingly small probability of large investment losses. The distribution of price returns of these instruments is asymmetric and highly skewed, exhibiting very flat tails on the downside. Investors are compensated for assuming the low-probability risk of exceptionally large losses. However, models for integrated risk management in the context of credit risky securities remain scarce and these instruments, in practice are naively included in portfolios.

Properly simulated credit events result in risk profiles with flat tails on downside risk (i.e., losses) and limited upside potential (i.e., gains). Subtle and important observations include:

– Losses are probabilistic events, and without adequate accuracy the low-probability events may be missed.

– Recognizing these low-probability events can lead to different optimal portfolios.

– Standard risk measures do not adequately penalize the low-probability events. The resulting portfolios might be efficient with respect to the standard popular metric of volatility, yet they are improper, because of the probability of achieving substantial losses. Different risk measures such as conditional VaR should therefore be used.

– With appropriate modeling, long-term performance goals can be met without suffering catastrophic blows from the tails in the short run. This is in practice rather hard to do, however.

The causes of loss due to credit assets are many and complex. Credit risk can be described as the changing expectations of an obligator’s ability or willingness to fulfill its obligations on a certain date or at any time beyond. Losses may result from a default or a change in market value due to credit quality migration. In general, credit risk for a single instrument may be decomposed into default risk, migration risk, and security-specific risks that cause idiosyncratic spread changes.

Popular approaches assess credit risk due to default losses only without taking into consideration the term structure of credit spreads; say calculation of the present value of a portfolio of credit risk-sensitive assets depending on existing credit risk only. Market risk is not incorporated explicitly. As a result, no other risks apart from credit risk can be assessed for their impact on the valuation of a portfolio that includes risky credits.

It is important that popular pricing models be extended to the valuation and simulation of portfolios of credit risky securities and their derivatives. These extensions must allow estimating the risk profile of portfolios considering market and spread risk, and the risks of rating migration, defaults, and recovery. Simulations ought to reveal—and quantify—the flat tails due to credit events.

Typically, simulations tend to show a flat lower tail when credit rating migrations are simulated under current economic conditions. This tail is absent when simulating only market and spread changes under constant volatility. The tail however can be quite pronounced when simulated assuming the term structure of risk-free rates. A proper approach should develop the simulation of the same portfolio integrating market and credit spread risk, and then adding the credit events, i.e., credit rating migrations and defaults. Improved simulation may take the form of accurate numerical methods for tail resolution or the use of confidence intervals for the extremes of the loss distribution, or any other technique that allows us to observe the tails that drive low-probability events. This observation has ramifications for the choice of an appropriate risk metric for portfolio optimization.

Tail Effects on Optimization

Ignoring the tails has a significant effect on arriving at portfolio efficient frontiers. There is nothing efficient about optimized portfolios obtained by ignoring the tails once the tails are properly accounted for. Tails distort the risk-return frontiers, making seemingly efficient portfolios inefficient ones. Running a mean absolute deviation (MAD) portfolio optimization using the distribution with credit events, may help obtain a frontier that is remarkably close to the out-of-sample frontier and eliminates inefficient portfolios.

Does this imply that it is sufficient to accurately simulate the tails, and then develop portfolios that optimally trade off expected return against risk? The answer is of course affirmative, although the MAD risk measure does not properly account for the tails. The distribution of returns of a minimum-risk portfolio obtained using the MAD model would suggest that there is a small probability of losses, often more than 80% of the portfolio value. These losses are likely to be catastrophic, and when they occur, they will most likely — due to bankruptcy — block the prospects of the long-term expected return. The long-term expected return of the minimum-risk portfolio will be realized only if the portfolio is not ruined in the short term.

Accounting for Tail Effects

What then should be done to properly account for the tail effects?

Losses are calculated relative to the exposure that would exist, at a given time horizon, if all obligors maintained their current credit state. Since credit events (i.e., default or a change in credit rating) are relatively rare, the peak of the loss distribution is typically at or near zero. It is important to keep in mind however that the loss distribution is highly skewed; a long-left tail reflects the infrequent, but substantial, losses that can occur when an obligor defaults. Conversely, negative losses (i.e., gains) can result from a net improvement in the credit ratings of obligors.

The answer is to select a risk metric that penalizes appropriately extreme events, and then optimize the portfolio composition with respect to this metric of risk. Relevant measures capture key properties of the loss distribution while tractable measures can be optimized using computationally efficient methods such as linear programming. The expected losses equal the mean of the loss distribution. The maximum losses represent the largest loss that is anticipated to occur with a given probability. The unexpected loss is the difference between the maximum and expected losses. Expected shortfall, also known as tail conditional expectation or conditional VaR, measures the average size of a loss given that it exceeds the Maximum Loss. One attractive feature of expected shortfall is that it considers the entire tail of the loss distribution (beyond the Maximum Loss), rather than just one point on the loss distribution. Thus, expected shortfall is more likely to draw attention to large losses in the extreme tail of the distribution than Maximum Loss which effectively ignores losses beyond the specified quantile level.

Variance is generally not a relevant credit risk measure, while maximum losses and unexpected losses are relevant but not tractable. Value at Risk (VaR) has become an industry standard for measuring extreme events and integrating disparate sources of risk. VaR answers a particular question: What is the maximum loss with a given confidence level (say, α × 100%) over the target horizon? Its calculation also reveals that with probability (1 – α)100% the losses will exceed VaR.

The VaR measure reveals nothing about the extent of the losses beyond the given confidence level. Such losses can be catastrophic and Long-Term Capital Management (LTCM) is a classic historical case in point. LTCM was estimated to have a VaR of only –5% at the 0.95 probability level, but a return of around –80% wiped out a position of $1.85 trillion and threatened a global meltdown of the financial markets. A measure of risk that goes beyond the information revealed by VaR is the expected value of the losses that exceed VaR. This quantity is called expected shortfall, conditional loss, or conditional VaR; CVaR is always greater than or equal to VaR.

It is also important to keep in mind that VaR is difficult to optimize when it is calculated using discrete scenarios. The VaR function is non-convex and non-smooth, and it has multiple local minima. CVaR, however, can be minimized using linear programming formulations. In other words, to avoid distortions of the efficient frontier due to the tail events, we need to optimize a risk metric that appropriately penalizes the tails. CVaR, as mentioned earlier, provides such a risk metric. The risk profile of a portfolio is shaped by the attention the risk manager pays to the tails. Taking a CVaR perspective on risk management substantially reduces the tails. Of course, the choice of a risk metric influences the upside potential of the portfolio and inevitably the upside potential is reduced as the tails are shrunk. There are the usual trade-offs between upside potential and downside risk, but in the context of credit risky securities the downside risk is hidden in the tail and not in the variance or the mean absolute deviation. In this respect CVaR has an important role to play in tracing efficient frontiers for the management of credit risk. CVaR optimization provides the appropriate risk management framework for credit risky portfolios.

Long Term Performance with Short Term Tails

Optimization of portfolio performance for the long run ignores the short-term effects. This has been the tradition in myopic single-period optimization models. Ignoring the short-term effects however can be catastrophic in the presence of tails. In particular, the long-term (expected) potential of a portfolio strategy may never be realized if an extreme event in the short run results in bankruptcy. LTCM is a case in point again. When LTCM suffered losses of 80% in 1998, the New York Federal Reserve orchestrated a bailout. Fourteen banks invested $3.6 billion in return for a 90% stake in the firm. The fund eventually recovered its losses and posted positive returns, but the original stakeholders were not there anymore.

Conclusion

The risk/return trade-off has been a central tenet of portfolio management since the seminal work of Markowitz. The basic premise, that higher (expected) returns can only be achieved at the expense of greater risk, leads to the concept of an efficient frontier. The efficient frontier defines the maximum return that can be achieved for a given level of risk or, alternatively, the minimum risk that must be incurred to earn a given return. Traditionally, market risk has been measured by the variance (or standard deviation) of portfolio returns, and this measure is now erroneously widely used for credit risk management as well. While this is reasonable when the distribution of gains and losses is normal, variance is an inappropriate measure of risk for the highly skewed, fat-tailed distributions characteristic of portfolios that incur credit risk. A minimum-variance portfolio is far from efficient with respect to unexpected losses that occur in credit investing. In this case, quantile-based measures that focus on the tail of the loss distribution more accurately capture the risk of the portfolio. It is only after taking account of the above, should investors consider the excess return, or “spread,” which represents a risk premium that compensates investors for potential losses due to credit events (and possibly illiquidity).

An Earnout is a Useful Tool to Bridge a Valuation Gap

  • An earnout is an acquisition where the purchase price is partially contingent on the future performance of the target
  • Bridge a valuation gap
  • Used when possible, to measure target’s performance post-closing
  • Retention and incentive mechanism for owners/operators to stay past closing
  • Typically used in smaller deals (less than $500 million)
  • Usually tied to an accounting metric
  • Revenue, gross profit, EBITDA, EBIT, net income
  • Accounting metrics need to be able to be verified and audited
  • Earnouts are highly customized for each situation
  • Typically negotiated later in the M&A process
  • Structure can have tax and accounting implications
  • Time period can range from 1-5 years
  • Shorter time is more common (3 years and less)

Bridging the Value Gap

There are three key issues that will drive the value gap:

  • Expected operational performance of the asset
  • Valuation multiple to be applied to the operational performance
  • Buyer and/or seller requirement for a “headline” value for various relevant constituencies (i.e. limited partners, shareholders, banks, bondholders, etc.)

Two of the mechanisms that can be used to bridge value gaps are:

  1. Earn-Outs: Potential future cash or stock payments based on achieving pre-determined operating/financial targets
  2. Contingent Value Rights (CVRs): Potential future payment (usually of stock) based on stock price performance

Earn-Outs

  • The successful execution of an Earn-Out agreement requires simple and measurable criteria:
  • Careful selection of criteria and structuring of the pay-out formula
  • Agreement on accounting methodologies so neither party can manipulate base data
  • Agreement on who controls the business during the Earn-Out period
  • An arbitration system to resolve any future arguments

Advantages

  • Reduces risk of overpaying if poor operating performance post-acquisition
  • Only structure that “tests” Target Parent’s convictions of Target’s potential
  • Could help Target Parent state a higher headline value for the sale

Considerations

  • Not a common structure for public companies
  • Adds complexity to deal
  • May result in Acquirer paying for value that it creates within Target
  • Potential for manipulation in areas of management (short-term gains) and accounting
  • Potential for litigation if future value not achieved

Understanding Long Term Capital Management Failure Using Minsky Model

Long Term Capital Management (LTCM), a hedge fund, was an investment structure for managing a private, loosely regulated investment pool that invested in both cash (physical securities) and derivative markets on a leveraged basis. My essay analyzes the failure of LTCM in September 1998 using the Hyman Minsky model and provides recommendations for policy makers to avert similar future crisis.

According to a Wikipedia entry “Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky stated that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.”

LTCM is a case study in exceptions — extreme, undiversified portfolio exposures in extraordinary market conditions. It did not, and does not, represent the hedge fund industry in general. The main reason for LTCM’s debacle was a lack of control of liquidity risk. Hedge funds can fail either because they are insolvent, or because an aggregate shortage of liquidity can render them insolvent. LTCM’s failure could itself have caused liquidity shortages leading to a cascade of failures and a possible total meltdown of the system. This risk of contagion could lead to a contraction in the common pool of liquidity. Therefore, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact, and can each cause the other. It is therefore hard to determine the root cause of a crisis from observable factors. 

LTCM was founded in 1994 by John Meriwether, a former Salomon Brothers trading star, along with a small group of associates including Nobel Laureates Robert Merton and Myron Scholes. It became an immediate success. By the end of 1997 it had achieved annual rates of return of around 40 percent and had nearly tripled its investors’ money. 

The main strategy implemented was fixed income arbitrage. It is a market neutral hedging strategy that seeks to profit by exploiting pricing inefficiencies between related fixed income securities while neutralizing exposure to interest rate risk. Managers attempt to exploit relative mispricing between related sets of fixed income securities. One example is to long relatively cheap off-the-run treasury bonds and short relatively expensive on-the-run treasury bonds of the same maturity at the same time. Supposedly both bonds will have the same future cash flows and their price will converge and the arbitrager can make a profit when that happens. Normally the spread between on-the-run and off-the-run treasury bonds are small, so LTCM used leverage to amplify the returns. By early 1998, the leverage ratio (asset-to-equity ratio) reached 16:1, which is extremely high.

First, in terms of the Minsky model, there was an exogenous shock when Russia defaulted and there was a flight to quality – to mostly on the run US Treasury bonds. In the summer of 1998, the market deteriorated and LTCM began to suffer losses in July. One month later, Russian government devalued the ruble and declared a moratorium on future debt repayments. Those events led to a major deterioration in the creditworthiness of many emerging-market bonds and corresponding large increases in the spreads between the prices of Western government (especially US treasury bonds) and emerging market bonds. And immediately a massive “flight to quality” by general investors ensued, with investors flooding out of any remotely risky market and into the most secure instruments. Trades that were expected to converge did not do so. 

In terms of Hyman Minsky’s model, the boom created by the profit opportunities after the shock is fed by increasing money supply. LTCM’s fund presented new opportunities for even higher returns. Actually, it meant an opportunity for LTCM if it did not have the high leverage they were using. Given panicking investors and “flight to quality”, the most secure instruments’ prices were driven artificially high and the spread became larger as the models would suggest. If the market prices finally converged to the underlying value, the wider initial spread would indicate higher profit. So even though LTCM’s portfolio was down 44 percent for the month of August, there was potential opportunity for it to recover. It led to speculation that initially had positive feedback; speculators earned money and invested more, which encouraged more people to invest. In a letter CEO Meriwether wrote “On the other hand, we see great opportunities in a number of our best strategies, and these are being held by the Fund”. He also reminded that investors to keep in mind that the Fund’s relative-value strategies may require a long convergence horizon.

Minsky emphasized the inherent instability of the credit system and attaches importance to the role of debt structures in causing financial difficulties. This happened in the LTCM case for it was highly leveraged. After having had returned capital to its limited partners its leverage ratio went even higher to fund the acquisition of speculative assets for subsequent resale. LTCM’s deterioration was dramatically exacerbated by its high leverage ratio. By early September, the leverage ratio had climbed to 45:1. Considering high volatility due to the market instability, that’s an extremely high number by all standards.

Minsky stresses the role of pure speculation and excessive gearing. LTCM often took the opposite ends of the trade and was a provider of liquidity to the market. Minsky’s model is limited to single country, but in this case speculators were overtrading in London and other overseas markets too. The panic fed it until the prices became very low and trades were cut off. The actions of distressed parties attempting to reduce the size of their balance sheets had an impact on the value of others’ assets. Weakened balance sheets generated further forced sales, feeding the vicious circle. The liquidity squeeze generated by such forced sales exacerbated the crisis.

The models used by LTCM, although complicated, did not give liquidity risk the importance it deserved. Two bonds might have the same underlying cash flows, yet they can be priced differently exactly because they have different liquidity risk. So in the short run, the market value doesn’t simply reply on fundamental values. Most of the assets LTCM longed were illiquid and the assets they shorted were liquid ones. As “flight to quality” happened, more liquid assets were priced even higher and the spread widened instead of narrowed as the long-run expectation. Because of consecutive losses, the Fund had increasing difficulty meeting margin calls and needed more collateral to ensure that it could meet its obligations to counterparties.

The Fund was running short of high-quality assets for collateral to maintain its positions, and it also had great difficulty liquidating its positions: many of its positions were relatively illiquid (i.e., difficult to sell) even in normal times and hence still more difficult to sell—especially in a hurry—in nervous and declining markets. To preserve and raise the cash needed for operation, LTCM limited investors’ withdrawals and encouraged them to put more cash into the Fund. But it did not get the positive response that it much needed from the investors. The situation continued on deteriorating in September, and the Fund’s management spent another three weeks looking for assistance in an increasingly desperate effort to keep the fund afloat. However, no immediate help was forthcoming, and by September 19 the fund’s capital was down to only $600 million. 

Hedge funds should continue to have the flexibility they have for they bring liquidity, take speculative positions, serve as diversification classes and bring efficiency to the markets. The case for regulating hedge funds and possibly prevent another LTCM debacle should be seen from a perspective of a) protecting consumers b) protecting market integrity c) preventing systemic risk.

Since hedge funds are allowed to solicit investments only from high net worth individuals, protecting retail consumers is not a very important issue. However, the regulatory framework should ensure that hedge funds do not abandon the risk profile investors have been led to expect. While it is unjustified to ask for full disclosure as mutual funds do, more transparency, especially in explaining the risk involved, should be required. Hedge fund managers should disclose the underlying risks involved for each specific fund and explain the driving forces of the risks so that investors are better prepared to understand and manage their portfolio risk. In this case had LTCM provided more disclosure to its investors on the nature of its trades, its leverage ratios etc. it might have led to greater confidence in its operations

LTCM was able to borrow such large sums of money and leverage itself up by using collateral to borrow. It bought more assets, and these were used as collateral to borrow more money perpetuating a vicious cycle. This could have been prevented if there was one coordinated agency keeping track of its leverage. Many prestigious banks and influential individuals had lent to LTCM. Government policy can be enacted to monitor the interconnection between banks, hedge funds and other participants.

In the LTCM case we see that potential losses need not have arisen from direct credit exposures to the LTCM, but from the proprietary trading positions of banks, similar to those of the LTCM. This made the creditor banks similarly exposed to market movements that would have followed a forced liquidation of the LTCM. Government regulation were enacted after the global financial crisis to set limits on proprietary trading positions. 

With the wisdom of hindsight subsequent waves of crisis could have been prevented from happening was by acute awareness that there are limits to how much risk can be hedged away. Aggregate risk is there in the financial system even though each individual hedge fund may have hedged its own risk away. The risk as we see in LTCM’s case is increased co movement of prices, increased correlation between credit risk and counterparty risk.

Lastly liquidity risk can have a devastating effect on a highly leveraged financial system. As LTCM attempted to dispose its own assets, the negative price impact of this action impacted on the balance sheets of all others. First of all, LTCM’s counterparties would incur direct losses as their contracts remained unfulfilled. Secondly, and this was a much more serious threat, a disorderly unwinding of LTCM’s positions would have led to an even stronger downward movement of asset prices, which would affect even those banks who did not maintain direct relationships with LTCM. These dangers were amplified by the fact that many other firms had followed very similar strategies as LTCM and were, thus, subject to the same risks. And as per Minsky’s Model the market stabilizes after intervention from a lender of last resort intervenes (the Fed here) or orchestrates a resolution. When the New York Fed organized LTCM’s rescue by its creditors, it was for fears of systemic repercussions, rather than bailout perse.

Reasons Why Retail Investors Ought Not Copy the Endowment Model —–

The legendary David Swensen took over Yale University’s endowment in 1985 when it was worth $1.5 billion and grew it to $31 billion. He revolutionized endowment investing and recently passed at the age of 67. Is there a place for the retail implementation of an endowment investing approach? 

The demonstrated outperformance of some endowments, especially Yale, naturally begs the question of its applicability in a retail setting. Although some aspects of endowment style investing are transferable, there are factors unique to retail investors that we need to be aware of while considering implementations of this approach. A financial endowment is a transfer of money or property donated to an institution, usually with the stipulation that it be invested, and the principal remain intact for a defined time period. Endowments have limited liquidity needs, significantly long investment horizons and the ability to pursue less liquid asset classes more aggressively. In contrast, individuals have higher liquidity preferences and a finite investment horizon that is closely linked to one’s particular unique circumstances.

The goal should not be to simply copy the leading university endowments for these differ from individual investors in many important respects. Here is why.

Liquidity

Liquidity needs for traditional endowments are vastly different than for individual investors. Endowments and the institutions they benefit are managed on the basis that they will exist in perpetuity. As a result, liquidity is not a major priority as the endowment is tasked to provide enough inflation-adjusted annual income to support operations. These distributions are determined by very specific spending policies. Because these limited spending policies dampen the consequences of portfolio volatility, portfolio managers gain the freedom to accept greater investment risk with the expectation of achieving higher returns without exposing the institution to unreasonably large probabilities of significant budgetary shortfalls. Individuals do not operate in this manner. They have a limited life span and spending needs can be highly uncertain, thereby resulting in very different liquidity preferences. In a retail application, advisors tend to address individual liquidity needs through four, and perhaps more, mechanisms:

a) An increase in allocation to investments in liquid absolute-return alternative mutual fund and hedge fund like vehicles;

b) Use of a tender process to control and dampen the volatility associated with uncontrolled redemption pressures;

c) Letters of credit to meet temporary shortfalls in liquidity in the case of private bank sponsors; and

d) Utilization of subscriptions to offset redemptions.

These mechanisms are not needed in a traditional endowment, but are essential components in a retail setting.

Asset Allocation

Traditional endowment portfolio fiduciaries place asset allocation at the heart of the investment process, emphasizing policy portfolio decisions over market timing and security selection activities. Satisfaction of long-term institutional goals depends in large part on the underpinnings of successful asset allocation: an equity bias to provide high returns, and diversification to produce an acceptable level of risk. In a retail setting, however, individual client needs necessitate the re-tooling of the purist endowment model to meet liquidity preferences and finite time horizons.

Pricing & Valuation

Another major issue in a retail platform is pricing. Endowment trustees do not manage their portfolios on a month-to-month basis. As such, the reliability of an NAV in any given month is not of critical importance. However, in a retail solution, the need to produce reliable NAVs is crucial if one is to drive a successful client experience. Even when a reporting procedure is decided, fund sponsors are burdened with the challenge of striking a reliable NAV each month. Retail investors and their advisors would rightfully ask questions such as “are they averaging up or averaging down? How will the NAV be adjusted to reflect this and at what intervals?” These are very practical questions that one must be prepared to answer. Unreliable, pro-forma NAVs undermine the client service experience so essential in the retail segment.

Valuations of portfolio assets also present another hurdle. The combination of liquid and illiquid asset classes in the traditional endowment make accurately valuing such assets very difficult and costly. Traditional endowments have vastly different investments across an unlimited time horizon with different risk and return characteristics. Trustees are well aware of this fact as policy portfolios are constructed to take this into account. In contrast current and precise valuation is of particular importance when the retail investor has to undergo tax and/or estate planning – issues endowment trustees do not have to grapple with.

Transparency

A corollary to the pricing and valuation issue is investor transparency. Because of the highly illiquid and proprietary nature of endowment portfolio investments, it is exceedingly difficult to ascertain precise allocations. Underlying manager secrecy, in the retail world, can create information asymmetry between investment advisors and their clients – something that is frowned upon. 

Taxation and Tax Reporting

Endowments do not pay income tax. Taxation and tax reporting are concerns that retail investment advisors and their investors are not only tasked to do, but obligated to perform under state and federal laws. Folks invested in alternatives already accept a delayed K-1 due to private equity investments. The addition of real assets, such as land and timber, oil and gas, would delay this mandatory reporting even more which has the possibility of eroding valuable client relationships. Of particular importance in regards to taxation is the generation and subsequent reporting of income sourced via investments in multiple states. A high level of transparency is needed, especially in regards to real estate and private equity investments, to identify income earned for nonresident partners. Investors need to know two seemingly basic facts: a) do they need to file a composite return? and b) are multiple state filings required? This issue is not a significant concern to educational endowments due to their tax exempt status, but can have major operational implications for investment advisors that have to determine this in the most timely and efficient way possible. 

Size

Endowments, given their large size can negotiate special arrangements with investment managers. Retail investors, unless they are part of aggregated pools in feeder vehicles cannot usually have access as well as strike preferential agreements with product sponsors.

Longer lives

In theory, universities can live forever and therefore have a much longer investment horizon than an individual. Harvard, for instance, has been around since shortly after the Pilgrims landed on Plymouth Rock. Because of that longer view, elite endowments typically depart from the traditional liquid stock and bond mix by allocating a significant portion of their assets to less liquid, often non-publicly-traded alternative investments such as venture capital, private real estate, managed futures, natural resource partnerships as well as oil and gas.  

Conclusion

This piece explored the applicability of an endowment style approach to investors in the retail investing space, discussed specific issues unique to retail and suggested how multi-asset class model portfolios may be constructed. Understanding the differences between endowments and individual investors allows discerning advisors to determine the tools, vehicles and techniques that can successfully translate the success of endowment investing down to the household level – thereby better addressing retail investors’ special investing needs. In general, for the reasons outlined earlier the endowment approach is not easily transportable to retail investing. 

Author: Sameer Jain

Lightly excepted from a previous article by the author “The Household Endowment Model – Adopting Lessons Learned from the Nation’s Top Education Endowments”

Inside the Mind of Supreme Leader of North Korea, Great Successor & Divinely Perfect Kim Jong-un

Summary: This essay makes the case that North Korean leader Kim Jong-un is a rational actor. However, everything about his background and unique perspective will cause him to see the world differently from the way Westerners do. His actions are motivated with his regime’s survival & state control, economic sustenance, domestic stability as well as international legitimacy (right to exist). It offers a flashback to the early 2000’s to illustrate with a hypothetical, the regime’s decision-making process. And with historical perspective explains why in 2021 the situation in North Korea is what it is.

Introduction

In trying to understand North Korea’s foreign policy, it is easy for a Westerner to slip into systematic difficulties which lead to misinterpreting North Korean intentions. We may say “Oh Kim Jong-un ….. he’s really just like us… only Asian….” On the other hand, we may say “he’s just plain crazy!”. Both approaches are not without their merits, but they also carry the danger of naivete. It is important to also consider a third approach; that Kim Jong-un is quite rational, but that everything about his background and perspective will cause him to see the world very, very differently from the way we do.

His reasoning may well be “Regarding lives lost due to famine/inefficiencies and the corona pandemic: We greatly honor and respect those who’ve perished to preserve the nation in these perilous times. Our mortal enemies are gathering around, led by the U.S., which has invaded our country …supported by Japan, which has invaded our proud nation many, many times”.

We must hark back to the time after WWII when ideas, words, ideology mattered. In important ways, North Korea is more a feudal state rather than a socialist one. The brutal Japanese occupation of Korea was preceded by the home-grown Yi dynasty; 500 years of the purest Confucian state the world has ever seen. North Korea has inherited that style of filial loyalty, and allegiance to ‘Dear Respected’ Kim Jong-un is strong. That is the background for North Korea’s present actions – occupation by Japan until 1945, hard-won independence, a devastating war which has never officially ended, and a world of hostile enemies. Kim Jong-un is still at war in his own mind. Some U.S. allies have said he is crazy because of his human rights deficiencies or apathy to the number that languish and die every year. But remember, in times of war, as they view them, standards are different. Sacrifices for the nation are to be expected. Kim Jong-un rules in a country which has had 600 years of Confucian order and loyalty to authority. Regardless of his problems, we should not expect that he is about to fall from power.

Kim Jong-un is a rational actor. While North Korean citizens may be insulated from world affairs, his regime has similar access to information as any other nation. His approach to interpreting world affairs should be no different than others’, but North Korea has quite different national and regime interests. These interests include the regime’s survival & state control, economic sustenance, domestic stability as well as international legitimacy (right to exist).

The world has changed much in the last 20 years and yet extraordinarily little has changed in North Korea. North Korean objectives in the early part of this century, as in 2021, included steps to enhance external and internal security, to deter U.S. aggression and to maintain South Korean, Chinese, Russian opposition to a U.S. attack. It wanted then as it does now to acquire tools and resources for economic development including food and fuel, technology transfer, removal of economic sanctions and to receive infrastructure aid. It also wanted then, as it does now to expand trade, investments and normalize relations with key powers without intrusions on its sovereignty. Faced with an increasingly hostile U.S. it then had to make tradeoffs between continuing nuclear development, whether to publicly declare its nuclear status (which it did subsequently), to negotiate and decide between which concessions to seek and those to make. It also needed to make the difficult decision that in the event an agreement was reached – ought it to cheat or not? Deep down, it makes sense to assume, North Korea still wants a true, ratified peace treaty which a) commits signatories to non-aggression, especially nuclear, b) commitments to forswear clandestine interference in its internal affairs, c) formally ends the Korean War, d) includes apology and reparations from Japan for a brutal colonial regime.

Flashback to Early 2000’s

Flashback to where our story begins. In January 2002, President Bush included North Korea in his “axis of evil” and left little doubt that his policy included serious thought to unprovoked attack, if needed as was rumored with small nuclear weapons. The North Koreans then moved away from their commitment to negotiating a solution to collective security issues, towards accepting that “Bush invades those who don’t can’t defend themselves; especially, those without nuclear weapons” as a confidante advised the late Great Leader Kim Jong-il. In short, the North Koreans felt insecure, unsafe, and scared. In their own way, they felt they were reduced to begging to negotiate for years; to come in from the cold; to end the war unilaterally. We should be aware that Korea’s own priorities were based on their concept of the Three Foundations; Ideology, Military and Economy, and attention since has always been paid to support pillars embodied in self-reliance, security, sovereignty.

In arriving at multiple options to inform a viable future course, one approach then was to develop robust deterrence. This entailed continued nuclear weapons development, to buy time for 18 months without intention to agreeing in the end, and when a more formidable deterrent was built, to retain option to negotiate. All the while, driving a wedge between South Korea and its key ally the U.S. while negotiating separately for food and fuel with China, South Korea, Iran and Japan. The benefits, they reasoned, preserved leverage and augmented defense capability, at the small price of foregoing aid. A second suggested course was to speed up its nuclear program but at the same time enter good faith negotiations with six parties China, Japan, North Korea, Russia, South Korea, and the U.S. The idea then being to seek stepped agreement of concessions in exchange for nuclear scale-back. This course entailed no cheating and implementing any agreement reached faithfully. The benefits were the possibility of obtaining real concessions. But the cost was lower defense capability and excessive reliance on trustworthiness of counterparties, especially on the U.S. at a time when trust was especially low. The hawks advising the late ‘Dear Leader’ Kim Jong-il, father to the present ‘Great Successor’ Kim Jong-un, had other ideas which may crudely be characterized as ‘negotiate & cheat’. This meant continued nuclear weapons development, reaching negotiated agreement with six parties while retaining the option to continue clandestine weapons development at any point. They reasoned that the benefits were the possibility to obtain concessions without permanent loss of defensive capability, though it did run the risk of the U.S. detecting cheating.

At that time, as in present times in their minds, there was considerable confusion about U.S. resolve and intentions. The U.S. was widely seen as an uncontainable mortal enemy bent on trying to topple the regime no matter what. A hawkish General may well have remarked in a national security meeting “U.S. foreign policy doctrine will not stop short of removing us. Nuclear controls are not enough – they see us as inherently threatening. No agreement we could make would be secure. Our strategy must be to deter attack, not hope for agreement”. He may have reasoned that the North Korean response ought to be primarily in terms of renewed military enhancement “Develop more fissile material, speed up Taepo Dong and No Dong missile development, ramp up missile mating technology”. Some moderates though, advising Kim Jong-il saw the U.S. as a containable strategic enemy, unlikely to attack if they played their cards well. The doves, and their voices were muted, saw the U.S. as a reasonable rival, one likely to be satisfied with nuclear de-escalation.

Situation circa 2000-2005

The world in the early 2000’s was concerned with Kim Jong-il’s machinations. Little is known about how the secretive Dear Leader viewed the world, as well as how he may have assessed choices facing North Korea, or how he might have viewed negotiations with the U.S. North Korea’s national interests were never publicized and neither was much known about how his actions might best achieve them. Condoleezza “Condi” Rice an American diplomat, political scientist, civil servant, and professor who served as the 66th United States Secretary of State from 2005 to 2009 and as the 20th United States National Security Advisor describes one nightmare scenario in a private conversation: “We get distracted, negotiations drag out, and North Korea suddenly conducts a nuclear test, declaring itself a nuclear state . . . . It will be much easier to prevent this from happening than figuring out what to do, once it does.” 

The World through Pyongyang’s Lens

After six-party negotiations in Beijing over the future of North Korea’s nuclear program, which included the U.S., Japan, Russia, China, and South Korea, Kim Jong-ilwanted to reexamine his strategy for survival as a state with a nuclear deterrent. Little was resolved at the Beijing summit beyond agreeing to further multi-party negotiations. The Great Leader, however, was particularly worried about issues that threatened security and integrity.

  • The Bush administration reiterated its “hostile policies” demanding the “complete, verifiable and irreversible disarmament” of both North Korea’s nuclear programs—civilian and military. Privately the Bush administration also called for an end to all missile sales—a measure that would virtually cripple the economy. 
  • China was less willing to defend Pyongyang than it had been in the past. North Korea would be in trouble if China scaled back economic and political support. 

At the Beijing talks North Korea declared it had “no alternative but to equip and strengthen itself to survive with a nuclear deterrent force.” Privately in Pyongyang, Kim Jong-ildemanded a wholesale reevaluation of North Korea’s strategic position and best options. He asked to be provided with strategic options assessing how to deal with the U.S. before negotiations resumed. Kim Jong-ilsaid that while survival with a viable nuclear deterrent was his preferred outcome, he would consider all options including a negotiated settlement, identifying the most effective carrots and sticks that each side may use.  

The Four Questions

The Dear Leader also said that if he knew the answers to four questions, he would know exactly how to handle the Evil Empire.

·       Under what circumstances would the U.S. be willing to attack North Korea?

·       What price would the U.S. be willing to pay in attempting to de-nuclearize North Korea—Would it risk losing Seoul or Tokyo? Would it spend as much as it did in oil-rich Iraq?

·       Could the U.S. be trusted to follow through with economic and security guarantees?

·       How important was North Korea to China?

Important Facts

  • The Bush administration had been split in dealing with North Korea. Its policy began as “ABC”—anything but Clinton. It was unwilling to offer carrots but was unwilling or unable to use serious sticks either.
  • The A.Q. Khan nuclear proliferation affair with Pakistan and President Bush’s tough talk on non-proliferation gave renewed emphasis on containing the further spread of nuclear weapons. 
  • AEIOU – Afghanistan, Elections, Iraq and Osama bin Laden provided enough cover for North Korea to operate Under theU.S. foreign policy radar. The correctly reasoned as one General put it “When these issues are resolved more attention and pressure will be applied to North Korea and Kim’s freedom to maneuver will diminish”
  • After South Korea’s partial rapprochement with the North under its Sunshine Policy and its tenuous relations with the Bush administration, the South did not appear willing to support a hardline Washington position, which ran a high risk of war.
  • North Korea was already close to becoming a real nuclear weapons state. In 1994, U.S. intelligence estimated that North Korea reprocessed enough plutonium for two bombs. Since the breakdown in 2002 when IAEA inspectors were evicted, North Korea had been reprocessing an additional 8000 fuel rods which provided enough plutonium for an additional six weapons. North Korea was refurbishing reactors, enrichment, and reprocessing facilities that would allow it to produce enough fissile material for an additional dozen weapons a year. And North Korea’s missile program continued apace which soon indeed posed a credible threat to Japan.

 Conflict History

 Negotiations

North Korea signed the Nuclear non-proliferation treaty (NPT) in 1986 but did not permit inspections until 1992. Inspections went poorly leading to suspicions that the Yongbyon nuclear reactor was being used to produce plutonium. In 1993 North Korea warned that it would leave the NPT but pulled back at the last minute. In April 1994 North Korea announced that it would move used fuel rods from Yongbyon without permitting international monitors, threatening to reprocess the fuel. During negotiations with the U.S., a North Korean representative threatened to turn Seoul into a “sea of flames” if the U.S. provoked war. With tensions at the boiling point and the U.S. contemplating surgical air strikes, Jimmy Carter persuaded Pyongyang to return to negotiations and permit inspectors to monitor the nuclear fuel transfer. 

In late 1994, Kim Il Sung died and was replaced by his son, Kim Jong-il, known to the West as a film loving playboy. The ensuing negotiations produced the Agreed Framework. North Korea agreed to shut down its Yongbyon nuclear complex and cease plutonium production. In return, a U.S.-led consortium including South Korea and Japan promised to finance the construction of two modern light-water reactors and providing 500,000 tons of fuel oil annually until the reactors were completed. Clinton’s Congressional critics were outraged, accusing him of appeasement. 

Sunshine and Daydreams

In 1998 South Korea initiated its Sunshine Policy designed to lure the hermit kingdom into the international fold through openness, engagement, and economic incentives to modernize the economy. Late in 1998 it unsuccessfully tested a long-range Taepodong 1 ballistic missile. After mild threats to terminate inspections due to delays in the construction of reactors, the Agreed Framework was reaffirmed when Madeline Albright visited Pyongyang in late 2000. 

Thorny Bushes

Upon taking office, the Bush administration reversed the Clinton-era policy of engaging North Korea—much to the shock of South Korea. When North Korea threatened to restart the Yongbyon reactor, Bush branded it as a “grave and growing danger” in an “axis of evil.” As relations deteriorated between the U.S. and North Korea in 2002, North Korea admitted to a uranium enrichment program, but refused to terminate it. The U.S. and South Korea cut off fuel shipments. North Korea restarted plutonium reprocessing and evicted IAEA inspectors.

Economic Shambles

1989 when the USSR ended its patronage, North Korea’s shriveling economy had grown dependent upon China’s munificence. North Korea progressively become an impoverished state unable to feed its population.  Agriculture then accounted for 25% of GNP yet was unable to prevent a famine during the 1990s. 60% of all children suffered from malnutrition.  

North Korea: Armed to the Teeth

Conventional Forces

North Korea had 500,000 troops on high alert poised on the DMZ and Seoul is just an hour’s drive south. Thousands of artillery pieces embedded in hills near the border were trained upon Seoul and dozens of Scud missiles were also aimed south. 37,000 U.S. troops were stationed along the DMZ to deter the North. Any pre-emptive attack by the United States—even a surgical air strike—could be met with a full-frontal assault that would kill several hundred thousand South Koreans. 

Missiles

North Korea’s missile program has been active, ambitious, successful, and popular in the global arms bazaar, contributing until sanction were clamped roughly one quarter of North Korea’s $700M in exports. The tested No Dong missile then could easily reach Tokyo though accuracy was limited. Then yet untested and only questionably operational, it was advertised that when completed and operational Taepodong 1 & 2 missiles would be able to deliver a nuclear device to the West Coast of the U.S. From a crude nuclear weapon to a sophisticated, miniaturized weapon that can be delivered by a missile is a further, serious technical feat, and the U.S. believed there was no evidence that North Korea was anywhere near this capability.

Nukes

According to a declassified CIA report, “North Korea has one or possibly two weapons using plutonium it produced prior to 1992.” A bigger question was the quantity of weapons-grade plutonium it has acquired via reprocessed nuclear reactor fuel rods. Best estimates indicated that North Korea had between 25-30kg of reprocessed plutonium, sufficient for constructing 5-6 weapons. President Bush made clear: “A decision to develop a nuclear arsenal is one that will alienate you from the rest of the world.”

Other WMD

North Korea had invested heavily in chemical and biological weapons. It had weapons-grade biological agents, including smallpox, which could be used in an attack on the U.S. 

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Hypothetical: Kim Jong-il’s Decision Making Process

Situation: North Korea’s National Interests

VITAL a) Ensure regime survival b) Deter U.S. attack

VERY IMPORTANT a) Secure maximum economic and food aid b) Maintain good relations with China and Russia.

IMPORTANT a) Secure economic relations with South Korea and Japan b) Eventual reunification of the Korean peninsula.

Objectives:

·       Secure U.S. guarantees of a) Non-aggression b) Economic and food aid c) Energy

·       Ensure China’s continued support of a) Diplomatic relations b) Food and energy

·       Secure South Korean and Japanese guarantees of aid/reparations and economic projects.

Option 1: Reach Agreement with U.S.

a) Reach a negotiated agreement with the U.S. as soon as possible b) Come to an agreement without security guarantees from the U.S. 

Pros: i) Reduces probability of U.S. attack ii) Guarantees some form of food aid, possible economic assistance iii) Gains credibility from China.

Cons: i) Leaves North Korea defenseless to U.S. attack ii) No guarantee that the U.S. will not attack North Korea iii) Looks weak internally iv) Foreign presence of inspectors v) May not get best deal

Option 2: Massive Military Build-Up

a) Developing WMD capabilities to get permanent deterrence to American attack b) Stall talks to buy more time for nuclear program.

Pros: i) 98% deterrence (if program successfully completed) against U.S. ii) Raises external/internal prestige iii) Permanent solution (if successful)

Cons: i) 90% risk of losing China’s support ii) International condemnation iii) Will worsen North Korea’s budget crunch iv) If U.S. discovers North Korea’s true intent to go hostile and use nuclear weapons, 90% sure U.S. will attack v) North Korea risks losing strategic ambiguity in talks.

Option 3: “Two-Track” Build-Up & Negotiate

a) Continue developing WMDs until all North Korea’s diplomatic needs are satisfied b) Hold genuine talks and keep North Korea’s needs clear and consistent.

Pros: i) Time favors North Korea’s diplomatic leverage ii) Low-Risk, High-Reward iii) Reduces risk of attack iv) Outcome either weapons or demands met v) Maintains international support vi) Continues useful ambiguity, deterring attack vii) Force the U.S. hand, while forcing them to operate in uncertainty about North Korea program.

Cons: i) U.S. may still attack ii) China may lose patience.

Decision Recommendation: Option 3: “Two-Track” Build-Up & Negotiate

a) North Korea’s progress toward WMD capability provides a major diplomatic edge b) North Korea should maximize this leverage — hold talks and as soon as North Korea’s interests are satisfied, STRIKE A DEAL c) If worse comes to worst, North Korea has the flexibility to fall back to Option 1 or 2.

U.S./REGIONAL PLAYERS GIVE a) Non-Aggression Pact b) Maximum economic assistance and food aid from the U.S., China, South Korea, Japan & the international community c) Normalization of relations with U.S. d) War reparations from Japan.

North Korea GIVES a) Verifiable dismantling of WMDs b) Stop missile sales in return for income-producing assets.

Implementation:

Stage 1: i) Continue talks ii) Communicate North Korea’s demands publicly and privately iii) Non-aggression pact iv) Food aid/economic assistance v) Normalization of relations with the U.S. vi) Work on nuclear programs secretly.

Stage 2: i) Warm relations with South Korea to keep wedge between U.S. and its key ally ii) Retransmit North Korea’s same demands iii) Continue nuclear programs secretly.

Stage 3; i) Drag out talks until all demands are met ii) Maintain ambiguity of WMD progress iii) Wrap up WMD construction secretly.

Stage 4: i) Give U.S. one last chance to agree ii) If negotiations fail, declare North Korea to be the next nuclear power. 

Answering Dear Leader’s Four Questions

1)    U.S. will attack when these conditions are met:

·       U.S. military commitment eases in Iraq, elsewhere

·       Iran, other “terrorist” nation is not more promising target

·       George Bush is reelected

·       U.S. believes North Korea nukes are imminent but not yet deployed and can be destroyed

·       U.S. believes North Korea artillery can be destroyed fast enough to minimize damage on Seoul

2)    Price U.S. is willing to pay to de-nuclearize North Korea?

·       Would jeopardize South Korea troops

·       Would jeopardize some U.S. troops

·       Would accept some artillery damage on Seoul if minimized

·       Would not accept attack on Japanese cities like Tokyo.

3)    U.S. clearly cannot be trusted:

·       U.S. violated 1994 Agreed Framework

·       Has missed deadlines for KEDO, heavy fuel oil

·       Bush has insisted military option remains open

·       Bush has shown disdain for international agreements

·       U.S. attacked another “Axis of Evil” state

4)    North Korea’s importance to China:

    (+) Keeps Korean peninsula from becoming unified, pro-American

    (+) Buffer state from U.S. troops

    (+) Old socialist ally, Chinese veterans of Korean War have pride

    (-) Potential source of border instability

    (-) North Korea nuke program is big diplomatic headache

    (-) North Korea nuke program threatens regional arms race, not in China’s interest

Author: Sameer Jain, lightly excerpted from a memo to Condoleezza Rice