Lehmans' third anniversary: How have fund managers changed?

The day of the Lehman Brothers collapse is one investment managers will never forget.

The Federal Reserve’s decision to let the Wall Street institution go bankrupt sent shockwaves across the world: panic ensued and shares plummeted in what has been described as the craziest 48 hours ever seen in financial markets.

The repercussions are still being felt to this day. The eurozone is in tatters, with a likely solution to the threat of sovereign debt default looking further and further away. Last month’s drastic sell-offs were a stark reminder of just how much the event had infected markets everywhere.

This time round, however, many managers found themselves in a better position to weather the storm. Perhaps a faint silver lining to the dark cloud of Lehman’s demise is that a number of risks were exposed, enabling managers to shape their investment processes in a way that would encompass them.

The risks exposed

For Richard Skelt, co-head of multi-asset investment at Fidelity, those risks fall into three main categories.

The first, systemic risk, was exposed instantly. The failure of just one bank caused a knock on effect across the world, highlighting the extent of which the global financial system was truly entwined.

“People were looking at the other banks and wondering which was going to be next. Banks stopped doing business with each other and that had a huge economic impact,” says Skelt.

The scenario brought counterparty risk to the fore. As with many investment managers at the time, Skelt witnessed the potentially toxic relationship between a fund shareholder and counterparties.

Thankfully, the UCIS structure of the fund in question meant the sour exposure was limited to around 3% of assets. Fidelity put in the sell order Monday morning and received the money back under normal fund processing on the Thursday afternoon.

But some were not so fortunate. Those invested in products such as hedge funds where Lehman was the prime broker had to wait a long time to get their money back, with some unsettled cases still ongoing. 

The final risk was that of liquidity, highlighted by the the performance of fixed income funds.

He says: “Credit was marked down and managers of corporate bond funds, for example, looking to sell assets would find no one was willing to buy at any price. In turn, many credit funds lost between 15-20%, a feat no manager would have accepted if you’d have told them 12 months previous.”

Impact on investment processes

Despite the rocky after-effects of Lehman, managers that survived 2008 had the opportunity to rewrite investment processes to include specific risk management.
Now, when it comes to ascertaining counterparty concerns, it is unlikely a fund manager will grow exposure to a single counterparty more than 5%, according to Skelt. There is also a greater emphasis on due diligence as to whom the counterparties are and what the exposure is.

Interestingly in today’s environment the same questions now extend to ETFs. Skelt says some ‘very complex’, swap based products raise particular concerns.

“What happens if some part of the counterparty structure is embedded and the ETF goes bust? If one leg of the stool is pulled out, it can be a very different exposure to what you had originally thought.”

Meanwhile, following the shocking performance of fixed income funds in the Lehman aftermath, Skelt re-examined his view on the sector. While 2008 was one of the best years for government securities such as bunds and gilts, non-straightforward government debt, such as index linked gilts, did ‘appallingly bad’, he says.

With this in mind, he now separates fixed income into four uses: flight to quality, duration matching, income or risk assets, and warns investors to define exactly what they want from that part of the portfolio.

“Do not confuse the four. Remember what you need from the component and make sure you have the right piece. If yields on governments are low, do not be tempted to go into corporates because you clearly do not want the risk that goes with it.”

Elsewhere, Julian Chillingworth, CIO, at Rathbones says the main lesson to learn is the sheer interconnectivity of asset classes, particularly in a market sell off.

In the three years since Lehman collapse, Rathbones has introduced a unique investment process within its multi-manager products. According to head of multi-asset at the group, David Coombs, “new risks need new approaches”.

The ‘LAB’ approach categorises assets into liquidity, alternatives and beta ‘buckets’, focussing on allocation by risk rather than geography or asset class.

The ‘liquidity’ bucket looks at assets such as cash, government bonds and high quality investment grade credit; ‘beta’ looks at assets such as equities, high yield credit and private equity; while ‘alternatives’ looks at gold and soft commodities, for example.

Strength of companies

Many fund managers have found the risks exposed by the bank’s collapse are increasing opportunities within certain asset classes. Equity managers in particular have seen a marked change in the strength of underlying companies.

Gary Potter, co-head of Thames River’s multi-manager team, suggests a change in attitudes at the company level has helped fund managers significantly.