Managing Liability Affects Stocks, Pt. 1

Consider the institutions that put in the bottom in the U.S. equity market back in September and October of 2002. European insurance companies and banks found themselves forced by their regulators to sell into the decline. Banks and insurance companies are leveraged by their very nature; the regulators concluded that another 20% decline in the stocks these companies held would imperil the solvency of the institutions. The leverage, plus the panicky regulators, made them weak holders in a decline.

Some investors don't buy on margin or go short, but still are weak holders due to their risk-control mechanisms. The smaller the loss that is tolerable, the weaker the holder. The smaller the gain desired, the weaker the holder: Daytraders are an extreme example of this.

Institutional equity managers often hold themselves to the rule that if a stock's price declines by more than 20% from their cost, they will sell the stock. Others will average down almost forever. Those who average down are stronger holders than those who have to kick the stock out.

There are other aspects of risk control that affect the strength of a holder. When I was a corporate bond manager, I paid careful attention when one of my brokers confided that his internal risk control desk was making him kick out a position or cover a short. Without being a major account, I gained the gratitude of major Wall Street trading desks by facilitating what they wanted to do, for a small profit for my clients. Because I ran life insurance money, I could be a stronger holder than an investment bank.

The definition of risk doesn't need to be loss. It could be how much a manager trails his peers or an index, either broad or style-specific. The fourth quartile of performance holds a particular dread for some managers because it can imply a loss of assets under management, fewer profits at the asset manager and lower bonuses for managers. There is a tendency for managers who are measured this way to become more momentum-oriented and index-like at the same time. If the manager takes a bet against the index and is wrong, he has two choices: He can chase the index to pick up exposure he is missing, or hope the deviation is temporary.

Think of 2003 with deep cyclicals; most active managers hate deep cyclicals, but when those stocks started running, active managers started buying them because the managers' performance was suffering without deep cyclicals. This made the run-up even more severe. Managers who ordinarily avoided buying momentum found themselves forced into being momentum managers in order to become more index-like in order to keep up with the indices.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].