I watched the end of the ARC ERM Launch Event 28th February 2019 again, and added to our partial transcript to reflect a penetrating observation by Malcolm Kemp at 1:46:30.
Malcolm rightly observes that the distinction between so-called real world and risk neutral is really about whether you recognise forecast excess returns in advance, or whether you wait to see if the forecast turns out correct.
If I expect extra returns, and I think most people do believe that there will some extra returns from risk seeking assets, unless there’s some kind of economic or political meltdown, then the question is, should I recognise those at outset, or should I recognise them over time as those returns actually appear. My personal view is that you should recognise them more over time as they appear, rather than taking advance credit for them.
Bang on.
‘Risk neutral versus real world’ suggests some arcane dispute about methods of valuation as though we were free to choose between one or the other. Some actuaries have even put it to me this way (‘no right answer’).
Yet, while every investor expects that they, or their fund manager, will realise returns over risk free at some point in the future – otherwise why are they investing in risky assets rather than boring old index-linked bonds – no sane person would pay a fund manager at the forecast, rather than the current market price.
Yet valuing a firm’s book at the forecast price is exactly what ERM firms are doing. This is great for existing shareholders, who benefit from the risky future returns up front. Not so good for prospective shareholders, who are going to pay away all the returns they might have got if they had invested in the risky assets themselves.
Crazy eh?