E. S. Browning in the Wall Street Journal reports on the growing signs that investment managers are showing signs of increased risk aversion in the face of rising global interest rates. While the article is a bit of a grab bag it reinforces some trends we have been noting on this site for some time.

Money managers are concluding that it’s time to cut back on their holdings of the volatile and increasingly speculative investments that until recently had been soaring — gold, industrial commodities, real estate as well as small stocks and many developing-country stocks.

“Starting in 2002 and 2003, it was ‘the riskier the investment the better.’ Now, the tide has shifted,” says Jeff Schappe, chief investment officer of BB&T Corp.’s BB&T Asset Management in Raleigh, North Carolina.

We had previously noted that megacap stocks could begin to outperform if private equity firms continued to drive merger and acquisition activity among the market’s largest stocks. After a strong run in small stocks these former bellwethers could be the recipient of the market’s largess as investors batten down the hatches.

Another area of risk-seeking, emerging markets, has also been a topic of note on this site. While the case for emerging markets is probably now stronger than it has been for some time, these countries are still at risk to rapid shifts in capital flows. Any one seeking a shelter would likely look to reduce their emerging market holdings.

The big, unanswered question for the markets is to what degree can risk really be reduced? The last few years the discussions of the capital markets have been dominated by the two interrelated trends. The first being the rising asset base and role hedge funds (and private equity funds) have played in the capital markets. The second being the effect that generally low global short term rates have played in many markets including real estate.

Most would agree that there is a relationship between these two trends. Cheap money in part fueled the attractiveness of many hedge fund strategies and made borrowing to buy entire companies attractive. Now that interest rates are rising on a global basis, including in Japan, the question is what happens to hedge funds and private equity funds. These vehicles are built on the assumption of risk. Institutional investors, who are now the dominant investors in these funds, are depending on these vehicles to provide them with above market returns. It will be difficult for this class of investors to simply ratchet down their risk levels in hopes of riding out a down cycle.

The smart investors will undoubtedly try to work both sides of the street. They can do this by simultaneously pushing their risk-seeking funds on one hand while preparing distressed debt funds to mop up those leveraged firms that are unable to make it through a down cycle.