Investment Safety - Why ask the question?

Has anyone asked the managers of her or his pension fund which is a safer investment for pension funds, debt or equity?

This latest financial crisis presented an opportunity to make such an analysis.

As I see it, there is only a relatively small difference in safety between the two, with equity being the safer in a general economic downturn and financial crisis.

Debt investment typically expects relatively low returns in the form of regular cash payments for interest. The return of capital may be regularly paid in cash or in the case of bonds may be delayed until the end of the term of the contract.

Equity investment may yield cash as return on investment in the form of dividends, by definition, being drawn from profits. The equities, generally shares or stocks, remain with the investor as part ownership in the enterprise.

When the enterprise is financially successful the dividends might be higher. The investment market will tend to recognize the increased security of the investment by driving up demand for the securities, thereby driving up the share price and offering an opportunity to gain on the investment.

On the other hand, the debt investment will yield regular return on capital in interest payments and return of capital by virtue of the repayment schedule. An enterprise debtor's financial success will only be reflected in reliability of those fixed or nearly fixed interest payments. Sudden large gains due to price appreciation of the debt instrument are unlikely to occur, as they would with equities.

When the enterprise is financially unsuccessful, it will pay no or smaller dividends, limited by the amount of accumulated surplus. The investor will still hold claim to a portion of the enterprise.

For a time, the debt investor will continue to receive returns in cash, both returns on and of capital. However, those returns will themselves threaten the solvency of the firm and might bring about its eventual demise. Will the debt investor recover all the investment? Perhaps, but more likely will recover only some of the investment with no chance of ever recovering the rest.

Of course, the equity investors face the same situation. They may recover something upon wind-up, or not.

Why ask this question when nearly every investor with even a passing knowledge of financial securities already knows these answers?

I ask it because I want fund managers to think about the implications of their investment decisions within the economic environment.

Ideally, fund managers would look for investments that pay cash returns on and of capital, while not being lost to catastrophic business failure.

The returns might never be as great as they might be with equity investments.

On the other hand, they might never be lost either.

We had pension and other wealth funds feeding the bubble economy for quite a few years. How do we know that? The funds' income was in the form of cash, usually the savings portions of employee income. Many funds were becoming cash rich, actually over-burdened with cash. They had to earn rewards that matched the investment markets so the piles of cash were more and more heavily invested in real estate, mortgages and equities.

These were almost all market risks, betting that the managers could continue to buy low and sell high indefinitely to meet future obligations to beneficiaries.

Betting that it will always be possible to buy low and sell high is the essence of a bubble market.

Fund liquidity and solvency needed to pursue other avenues to returns on and of capital that came only in the form of cash. These opportunities needed to be generating returns during good and normal economic times. The investment also needed to at worst lie dormant until economic times improved and returns could again be generated through economic activity. Perhaps these opportunities could be neither conventional debt nor equity investments, but some other form of investment.

Did fund managers look for such opportunities? We can't be sure. Apparently they didn't find them as I have not heard of a single instance where some fund manager emerged from the depths of the financial crisis with performance indicating such an opportunity was found and successfully exploited.

Such a fund manager would have appeared as a sunlit diamond in the rubble.

Mike