The 2001 Global Investing Conference

An exciting new acknowledgement of quantitative data and the importance of risk management.
By Paul Halpern, Toronto Stock Exchange Professor of Finance at the Rotman School of Management, University of Toronto

Increasing pension fund sponsor interest in the Global Investment Conference coupled with high-quality presentations and discussions confirm the importance of investments in non-domestic financial assets. This interest will grow over time with the easing of foreign property investment restrictions. Foreign investments could become even more important in pension fund portfolios if the federal government accepts the reasonable position of eliminating all foreign investment restrictions, thereby permitting pension fund sponsors to choose their optimum foreign investment position based on their asset and liability characteristics.

As international investment grows, so too does a number of important related issues; many of these issues were addressed in presentations at this year's conference. I will focus on two observations from the event, each of which warms the corners of my academic heart.

The first is the growing role and acceptance of quantitative data and analysis; the second is the importance of risk in the international investment context. Investment is about risk and expected return; understanding risk and deciding whether or not to manage it is crucial.

I will expand on the risk theme, but a short digression on the first is useful since it identifies an important issue in international investing--the waning role of global and local market influences and the growing importance of global sectors. These conclusions articulated at the conference are based on analyses of correlation coefficients with the caveat that historical correlation coefficients are becoming less useful for future periods as global market structures evolve. This observation is consistent with the growth of international diversification and the inherent contradiction of this growth--as world markets become more integrated through diversification investments, international diversification benefits diminish because correlations between markets become larger. What was most striking about these presentations was the high quality of the discussion surrounding these quantitative issues; it was not too long ago that presentations of this type would generate more yawns and frustrated looks than interested questions.

Risk factors in the international context include specific elements such as foreign exchange and the diversification issues of introducing specific investment classes such as hedge funds. What I found interesting at the conference was risk as related to information, or more precisely, unequal information between parties in international investing known as asymmetric information. Asymmetric information leads to problems both before a transaction is made (adverse selection) and after it is made (moral hazard).

In the first situation, a company's management has better information about its quality than do potential investors. Even with mandated information provision, asymmetries can persist. In this case, purchasers may end up with poor quality investments and pay prices unrelated to quality.

The second problem, resulting from difficulty in monitoring management behaviour once an investment has been made, permits management to undertake decisions against shareholders' best interests. Because of these influences, fewer investments will be undertaken and those that are undertaken will be at a discount to compensate investors for potential problems.

The problems of information asymmetries and problematic monitoring arose in a number of contexts during the conference. In one presentation, operational risk associated with global investing was highlighted. This risk was related to incorrect incentives, improper procedures and inadequate monitoring when control is remote from investments. As control diminishes, strategies must be implemented to hedge/manage operational risk. Further, making a non-domestic investment magnifies these problems since it is more difficult to obtain information and to monitor from afar. That is especially true for smaller firms or private equity investments.

These concerns may explain the strong observed home bias in portfolios, even in countries that do not have foreign investment restrictions. Home bias is found in domestic investments where geography plays an important role. For example, mutual fund investments within a particular distance from head office outperform investments beyond this distance. The implication for foreign investments is to use a local agent who has better local information and can monitor more effectively for investments with characteristics conducive to asymmetric information.

The third instance of information and risk was observed in managers' incentives to use aggressive accounting practices and their impacts on reported income and ultimately, share price. While many of the practices are known, allowance may not be made in financial analysis. The obvious example is the revenue recognition issue noted recently by the Ontario Securities Commission.

Many important issues were discussed at this year's Global Investment Conference. I chose to highlight the information issues due to the importance of information in valuation and company performance. While complete information provision cannot and should not be legislated, capital market participants, acting rationally, will provide the correct incentives to companies (management) to provide the needed information to assist in effective valuation.

Contex Group