Posts Tagged ‘Relative Value’

Systemic Risk, Multiple Equilibria and Market Dynamics – What You Need to Know and Why

Thursday, March 15th, 2012

  • ​ In assessing the possibility, duration and impact of systemic risk factors, we need to analyze the interaction of expectations with market (endogenous) and policy (exogenous) circuit breakers.
  • In the current environment, the prevalence of some subjective bimodal expectation distributions (e.g. Europe related) speaks to the multiple equilibrium features of sovereign debt markets.
  • Multiple equilibria give rise to a range of scenarios, each quite different and each with its own distribution of returns, risks, correlations, and market functioning.
  • In today’s global context, investors (as well as policy makers, researchers and opinion leaders) need to supplement their analyses of fundamentals, historic risk premia, correlations and relative value with a clearer delineation of the expectation formation process itself.

​Introduction
Financial markets are subject to periodic bouts of systemic risk that affect their functioning and stability, as well as investment returns and volatility. Several elements of investment strategy – including asset allocation, liquidity management, risk mitigation and, in certain cases, even the design of benchmarks and guidelines – can be affected by this reality. Accordingly, and particularly given the ongoing re-alignment of the global economy and markets, it is important to have a handle on the underlying dynamics. To this end, in this paper we analyze those associated with sudden shifts in expectations. It explains how they can morph into particularly disruptive multiple equilibria dynamics, and it points to possible implications for market outcomes, market equilibria and policy responses.

The Context
Earlier work in economics on signaling and screening, including by one of the authors of this article (Mike Spence), sheds important light on issues that are of current interest to markets and investors. Specifically, a significant subset of multiple equilibrium market structures – the ones that are most relevant to financial markets and to their interactions with the real economy – are those in which expectations have two characteristics: First, the expectations are endogenous – i.e., they are determined as part of the process of reaching equilibrium outcomes in the market. Second, they exert a substantial influence on behavior and hence on the market outcomes that are inherently linked with the expectations themselves.

The interactions of these two factors are critical. Indeed, if they are misunderstood, they can easily result in inappropriate analyses, investment decisions and risk management. They also can lead to misguided policy reactions.

If just the first characteristic is present, markets are in equilibrium when expectations are accurate. However, if both are present, then expectations aren’t best described as accurate but rather self-confirming in a serial manner; and the sequence of local equilibria need not lead to a global equilibrium. Consequently, it is this kind of structure that has multiple equilibria and hence the potential sudden shifts in both expectations and equilibrium market outcomes.

For financial markets, balance sheets and the real economy, the endogeneity of expectations is always part of the structure. But shifts in expectations and asset values need not always cause powerful feedback effects on investor behavior and/or the real economy. They do when a slight initial perturbation in expectations is amplified into a rapid, non-mean-reverting shift to a very different set of outcomes.

In assessing systemic risk, we therefore need to look for the conditions where there are substantial feedback effects and where market or policy circuit breakers are either missing, incomplete or uncertain.

Signaling as an Example of a Multiple Equilibrium Structure
Signaling occurs in market environments in which there are both informational gaps and informational asymmetries between the buyers and sellers. That is, there is some attribute of the product or service about which one side knows more than the other.

Asymmetrical information conditions are quite common. They occur in labor, financial and insurance markets, and in many more places. As an example, in insurance markets, the observability gap is variation in risk across the entities seeking to buy insurance. This phenomenon is called adverse selection. It leads to sub-optimal outcomes and market failures.

Incomplete information and the inability to distinguish cause a loss of product differentiation. Sellers try to recover the differentiation through signaling. For buyers, signals are visible attributes that sellers can acquire at a cost that, in turn, transmits information to buyers. Signals that survive and contain information in equilibrium have the property that their costs are negatively correlated with the invisible, valued attribute. If that condition is absent, the hypothetical signaling behavior of sellers will not be correlated with the underlying attribute. Subsequent market outcomes will reflect that, and the signal then loses its informational content and falls into disuse and out of the market equilibrium determination mechanisms.

Signaling has the two properties described above: Expectations are endogenous; and they exert a powerful influence on both incentives and choices made by sellers. Signaling models have multiple equilibria, in each of which the expectations are self-fulfilling.

In the current environment of large correlated global macro risks, we naturally tend to think mainly of dangerous equilibrium shifts – away from good ones and toward unfavorable bad ones that are also potentially unstable in that one bad equilibrium gives way to even worse ones in a serial fashion. But, importantly, it can go the other way too.

Yes, you can get stuck in a “bad” equilibrium. For example, in the developing country context in the early stages of development, there is an equilibrium in which there is relatively little growth and suboptimal investment – a bad equilibrium if you like. Any shock, endogenous or exogenous, carries a high risk of tipping the country into an even worse equilibrium. In such circumstances, the leadership and reform challenge is to shift the expectations and hence the underlying investment dynamics to a different and much more positive equilibrium. And it is here that a series of positive equilibriums can impose themselves, with significant implications for investment returns.

Ordinary Market Dynamics: Momentum and Value Investing
Financial markets have endogenous expectations. Investors know that expectations and prices can drift away from fundamentals, with a dynamic driven largely by the self-referential nature of the expectations. But there are limits.

In “normal” conditions, the feedback effects of asset price movements on the balance sheets of financial and other institutions (and of households) are not that large; and the wealth effect on activities in the real economy is small as a result. Moreover, arbitrage flows are subject to relatively low liquidity and risk premia.

So while a set of investors may base their choices on momentum and charts, others counter by basing their decisions more on deviations of market prices from some assessment of fundamental values, either short- or long-term. Trading frequency varies, as does the degree of dynamic portfolio reallocations and the premium that can be collected for selling volatility in different market segments.

Generally investors know that at least short term returns are determined in part by other investors’ expectations, but longer-term valuations will revert to levels warranted by the underlying fundamentals. As certain traders cause markets to move away from fundamental values (a mini bubble), the deviations become larger relative to the distribution of underlying value estimates. This entices value investors to move against the trends, thus causing a shift in the market dynamics back toward the central part of the fundamental value distribution.

Depending on the size and responsiveness of assets managed by each class of investor, the deviation from fundamental values can persist for awhile, but it gets pulled back. This can be thought of as a relatively harmless form of fluctuating multiple equilibrium. And it tends to give rise to attractive premiums that investors can capture by selling volatility, either directly in a range of markets (e.g., interest rates, credit, equities, commodities and foreign exchange) or indirectly and less comprehensively through certain asset classes (e.g., mortgages, corporate bonds, and emerging markets’ local rates, credit and equities).

In this rather common dynamic, the deviations are generally mean reverting as expectations shifts do not substantially affect fundamental values. This is not the case when, critically, feedback effects are large and the valuation anchor morphs into a moving target.

For example, in the aftermath of the 2008 crisis, the real economy headed down a highly correlated downward spiral along with the financial markets. Leverage caused a substantial part of the problem, as did pro-cyclical behavior on the part of markets and investors. The result was a significant, across the board repricing of markets, along with “atypical” developments in market correlations and the range of risk premia (including the liquidity premium). As a result, initial changes in asset values that in an unleveraged world would not have produced large real economy effects caused substantial balance sheet damage in the highly levered financial and household sectors. This led to large negative real-economy feedback effects and declining fundamental values. It wasn’t clear what the anchor was, or if there was one. That kind of structure can implode; and it would have were it not for dramatic and unprecedented intervention on the part of policy makers who aggressively substituted public balance sheets for rapidly imploding private ones.

The small feedback condition that we associate with normal stable market conditions was arguably also not what we saw last year in the European sovereign debt markets. Then, a yield run up in Italy or Spain threatened to shift the trio of market, political and policy incentives in such a way that it would have a major effect on credit quality. This had occurred already in Greece. More on this later.

Bank Runs
Multiple equilibrium structures are not new. History is full of examples where, absent effective policy circuit breakers, market realities deviated considerably from fundamentals, and did so in a sequential and increasingly disorderly fashion.

Consider the case of the banking sector. The normal levered configuration of banks (in a narrow sense, these are associated primarily with their maturity transformation as short term liquid liabilities fund longer-term and less liquid assets) is key to their role in funding productive investments in an economy. But it also makes them vulnerable to losses of confidence – a situation that was massively accentuated in the run up to the global financial crisis by prop activities and off balance sheet structured investment vehicles (SIVs) and other shadow banking activities.

Sometimes the change in operating paradigm is real, in the sense that the assets suffer some kind of permanent impairment resulting in negative equity. At some point depositors and creditors notice and a race for the exit starts. But as often observed, you do not need such a solvency shock to start a bank run. Just the perception of such a risk will do. Why? Because it is self-fulfilling absent government and central bank intervention. In such situations, solvency itself becomes endogenous.

Extreme bank runs are uncommon these days because governments guarantee deposits and central banks can and do move quickly to monetize the asset side of a solvent bank fast enough to keep it in business, even if the deposit run continues for some time, or if short term private financing in the market is cut off. Eventually the deposit run reverses, borrowing capacity returns, and the original equilibrium is restored.

The Internet Bubble of 2000-2001
The internet bubble of some 10 years ago is an interesting and slightly different case. Valuations of informational technology assets (publicly traded and not) got disconnected from reality, and had some of the characteristics of mini-bubbles described above. But the deviations from fundamental value were quite extreme.

The value investor market correction was delayed by the newness of the technologies and the temporary absence of relevant data to constrain the expectations. In this data-free environment, narratives, unconstrained by relevant experience (there wasn’t any), dominated, usually with a revolutionary, disruptive technology flavor. However, the data-free condition was not permanent. Eventually it became clear that, at least in the short term, forecasts of growth, relevance, revenues and earnings were way too optimistic. The markets experienced a major downward reset, with real economy effects that were large enough to cause a recession.

With hindsight, it seems fairly clear that the market distortions were not caused by an inaccurate specification of the ultimate impact of the technology. Instead, it was the substantial overestimate of the speed with which these new technologies would affect productivity, society and the global economy.

There are a variety of ways to describe this. Essentially, the value-investing anchor was present but much delayed. There were value and activist investors who were skeptics but, in the early stages, either they were less numerous in terms of control over assets or less certain of their views – hence the delay in responding.

The internet bubble was sufficiently large that it did, via the wealth effect, produce a shift in the trajectory of the real economy. For a while this effect was positive and reinforcing. But when expectations shifted and valuations reset, the reverse occurred and the real economy dipped to the point that the central bank opted for low interest rates to cushion the recessionary effect.

Standing back from these specific two cases for a moment, something is clear. In both, there were multiple equilibria affecting market activity, policy anchors and circuit breakers; and they ended up operating with varying speed and certitude.

Sovereign Debt and the Eurozone
Olivier Blanchard, the chief economist at the IMF, observed in his 2011 end-of-year remarks: “… post the 2008-09 crisis, the world economy is pregnant with multiple equilibria – self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.”

Consider the case of Italy last year. In May, Italian bond yields were relatively stable and well behaved. By August and again in November onward, unprecedented volatility drove them to dangerously high levels – enough to raise legitimate concern about the risk of a debt insolvency sequence.

With yields in the 6% to 7% range and the prospect that they might remain high as maturing low cost debt was increasingly refinanced via high cost debt, there was a material risk of a shift in expectations – not just on the market side, but also on policy incentives. The interactions of these expectations, including through feedback mechanisms, translated into mounting pressures on credit quality, yields, growth and policies. They also had social and political effects. And as the Italian stock market lost a third of its value, the wealth effect kicked in, helping to push Italy’s economy toward negative growth and debt deflation.

Sovereign debt in this context assumes the structural characteristics of multiple equilibria. The “credit risk” is endogenous. Perceived risk affects investor behavior, market prices, the incentives of governments and hence credit risk.
What are the circuit breakers or anchors in a situation like this? One parameter is the level of sovereign debt. Italy’s public debt-to-GDP is second only to Japan among the G-7 economies. That makes the cost of a rise in yields considerable.
In the low leverage case, you could argue that the anchor is the relatively low cost to the public finances of a rise in yields, breaking the feedback effect on credit risk. In that case, value investors respond to yield increases by increasing exposures and bringing the yields back down. Higher debt flows do the opposite: They change the incentive structure and amplify the feedback effect.
Second, with respect to a sudden shift in equilibrium, anticipated policy responses matter. In the Italian case, an aggressive assault on tax evasion, measures to liberalize labor markets and lift growth, and to dial back the parameters that determine non-debt public liabilities like pensions, with enough leadership to overcome the burden-sharing inertial forces that are present in any political system, would clearly reduce (though not eliminate) the risk. By contrast, prior to the arrival of the technocratic government under the leadership of Prime Minister Mario Monti, Italy had a government that was distracted, perhaps not fully aware of the risks, and losing popular support (as well as that of European partners). Even if it had attempted the kind of reform program that would have made a difference, there was heightened risk that probably tipped the markets toward the new equilibrium.
With a change in government and in policy approach, including meaningful support from the ECB via the long-term refinancing operations (LTROs), Italy had the ability to interrupt the negative multiple equilibrium dynamics at the end of 2011/beginning of 2012, thus lowering its borrowing costs. That was not the case for Greece, where the initial economic and financial conditions were considerably worse, there are legitimate questions about the political will to implement and sustain the reform process, and European partners and the IMF appear much more skeptical and hesitant.
The general awareness of the seriousness of the problem has risen substantially, but the issue of who across various parts of the economy and externally should bear the real costs of restoring fiscal balance and growth momentum remains. Even with the recent debt restructuring operations, or PSI (for private sector involvement), markets are pricing remaining unallocated capital losses that act as an impediment to solvency, growth and employment. As a result, fresh capital is largely refusing to engage notwithstanding yields that remain high.
It is important to stress the complementary potential circuit breakers formed by the external policy response – namely, the scale and scope of intervention from the ECB, EU and IMF (the “troika”) in the sovereign debt markets experiencing rising yields that threaten the effectiveness of and commitment to reform measures.
These entities’ interventions can and in some cases have succeeded to stabilize yields, buying time for the reform process to work. This is the case for the powerful LTROs.
By providing “unlimited liquidity” to banks on truly exceptional terms (1%, three-year maturities, and relaxed collateral requirements), the ECB has been instrumental in easing forced de-leveraging, minimizing the risk of disorderly deposit outflows, and preventing highly disruptive bank runs and payments problems. Some of that intervention also spilled over to sovereign debt markets.
But thus far, the ECB and the eurozone core have been unwilling to make unconditional commitments to intervene directly in the sovereign debt markets of Italy and Spain to stabilize yields. This reluctance is understandable and is probably due to concern about what might be called political or policy moral hazard: The concern is that such a commitment, while reducing the likelihood of the unattractive equilibrium, other things equal, might also reduce the incentive for reform by politicians and citizens. Since such reform is acknowledged to be essential to restoring stability in the eurozone, depending on which effect is larger, the intervention could be self-defeating.
Many knowledgeable observers believe that the intention in the eurozone core is to intervene, provided the reform process is serious and making headway, but not to announce this intention in order to mitigate the moral hazard problem. The problem then becomes the balance between proactive and reactive measures, as well as the ability to crowd in the private sector.
A similar kind of political moral hazard may have motivated German Chancellor Angela Merkel’s decision to insist on a parallel process of fiscal reform, in spite of the fact that such a process burdens a political construct that is already challenged by the process of restoring order in the periphery. The theory being that, in the sequential version, if and when things are stabilized, the incentive to do the institutional reform declines among politicians and electorates. It is a complex situation.

The USA and Japan
If this analysis is correct, then as the U.S. runs up its sovereign debt over time, there will be a gradual increase in the risk of a sudden shift in sentiment/expectations. Down the road, this could lead to an increase in yields and hence reduce fiscal space and policy flexibility. Political gridlock adds to this risk by lowering the perceived capacity to engage in corrective medium-term action on a timely basis, or to credibly commit to a multi-year term plan for fiscal stabilization and growth.
If expectations start to deteriorate on U.S. sovereign debt, there is no plausible external circuit breaker. It has to come from within the country. And the only plausible anchor to pull it back would be strong, disciplined, multi-year policy response that targets, importantly, both lower debt and higher growth. The longer it is delayed, the more expensive and riskier it becomes. While the leverage is probably not yet high enough to make the current equilibrium unstable, the return of the threat of a technical default in late 2012 or early 2013 could move the risks forward in time.
The U.S. Economy in the Decade Prior to the Crisis of 2008
The U.S. economy prior to the crisis was running with excess consumption, deficient public sector investment, government dis-saving, and a current account deficit reflecting a shortfall of saving relative to gross investment. In short, the economy was investing too little to sustain growth and saving even less.
Unlike other major developed economies, the U.S. ran a bilateral current account deficit with respect to almost every major country. Income and wealth distribution continued to deteriorate, and net employment creation in the tradable side was negative with especially large declines for the middle-income groups. The non-tradable side of the economy absorbed the incremental labor force with big increases in government and health care and a boost from excess consumption, especially in the labor intensive sectors, retailing, hospitality and construction.
Both the structural imbalances and the accumulation of public and private debt should have raised questions among policy makers and investors about the sustainability of the growth pattern over the medium-term, especially in the non-tradable sector, as well as about the political economy and distributional effects. But all of this is with the benefit of hindsight. Too many were insufficiently attentive to the powerful secular technological and global economic forces operating on the economy, overly sanguine about the sustainability of the growth pattern, and unable to accurately assess the rising systemic risks. As a result, on a rather large scale, the market and policy circuit breakers failed to operate, and eventually the equilibrium shifted suddenly and violently.
The crisis of 2008 wasn’t so much a 100 year storm but rather an accident waiting to happen. It is true that failures of regulation and risk assessment played important enabling roles. But the underlying problem was in large part a systematic pattern of unsustainable intertemporal choices, reflected in leverage, debt and a sense of unlimited credit entitlement. This led to a dynamic in both the real economy and the markets that constituted an increasingly unstable equilibrium. It broke in 2008, and we are in the somewhat lengthy process of shifting to a different equilibrium, what PIMCO labeled back in May 2009 the bumpy journey to a new destination (or a “new normal”).
Assessing non-cyclical macro systemic risk is complex: Accurately gauging the likelihood of an equilibrium shift is hard, and as a result, the anchors that prevent major deviations from realistic sustainable long run value creation are not necessarily present. But one lesson for policy makers and investors seems clear: It is unwise to assume stability and sustainability when underlying fundamentals are weakening.
Tipping Points
It is not enough for investors and policymakers to recognize the fuel for multiple equilibria dynamics. There is also the question of the spark, or what is known as tipping points.
Tipping points are shifts in the equilibrium when either fundamentals or expectations change course and then are legitimized by subsequent developments. Often they occur quite suddenly, with accelerations coming from technical factors. The exact timing is notoriously difficult to predict, raising the challenges for how markets, investors and policies should react and internalize/price this non-linearity.
From recent experience, question marks or changing views about policy responses increase the likelihood of an equilibrium shift by operating directly on the expectations. New data can have the same effect. Also, observation of market dynamics suggest that there are narratives and stories that affect investor behavior, and that when these narratives change, expectations and pricing dynamics can shift too.
But even for contrarians who detect the structural conditions early, predicting the timing has proved elusive, and the duration of the contrarian bet can be uncomfortably long. Generally, most scholars and analysts have concluded that it is impossible to predict the timing of an equilibrium shift even when the ingredients that create the rising potential instability and the possibility of multiple equilibria are present. The analogue in the sciences are systems that are called “critical states” whose movements behave according to fat-tailed power law distributions.
Bimodal Distributions, Multiple Equilibria and Investment Strategy
In the current environment, the prevalence of some subjective bimodal distributions on the part of investors can be viewed as a reflection of the multiple equilibrium features of a number of sovereign debt markets. This is especially the case in Europe where investors are torn between the prospects for fragmentation (reflecting both default and exit risks associated with the weakest eurozone peripherals) and recovery (driven by the core’s commitment to “refounding” the eurozone and the periphery’s adjustment efforts). Here the ramifications of a sudden equilibrium shift, good or bad, go well beyond the sovereign debt markets themselves, radiating out to the entire global economy.
Multiple equilibria give rise to two or more scenarios, each quite different and each with its own distribution of outcomes, correlations, market functioning and returns. Investors – and especially long-term investors in both financial and physical assets – are faced with the need to assess the relative likelihood of the scenarios, and then take a weighted average of usually two rather more normal looking distributions to end up with the bi-modal one. Whether it is in fact bimodal or not depends on the weights. Extreme optimism or pessimism will eliminate the bimodal feature.
This suggests that the tipping point can be crossed when the relative weight given to the non-status quo scenario starts to rise for a subset of investors. There is some emerging evidence that the short-term correlations, across and within asset classes, start to rise before a possible equilibrium shift. But that does not imply that the shift will occur. And when the correlations rise, the cost of the tail risk hedges also tends to rise.
Boldly betting on one or the other of the scenarios – i.e., either an extreme risk-off or risk-on posture – requires a very high level of conviction and foundation in an inherently “unusually uncertain” context. Similarly, positioning for the average of the two modes means that investors end up in the muddled middle – a “carry-laden” portfolio positioning that pays off only if the unsustainable is sustained.
A better approach revolves around the early detection of the structural bases for multiple equilibria accompanied by relative low cost tail-risk hedges. Absent that, for many investors, sitting on the sidelines and accepting low cash returns (and, in today’s policy-induced financial repression environment, negative real rates) until the bimodal features are resolved is understandable. How to do that used to be via a basket of “risk-free” assets; but with sovereign debt risk in the major economies on the rise, the menu of “risk-free” assets is being reduced, and yields on what remains have converged to very low nominal levels.
Conclusions
With too many advanced economies confronting the twin dilemma of too much debt and too little growth, and with systemically important emerging countries navigating the tricky middle-income developmental transition, today’s global economy poses unusual challenges for traditional concepts of asset allocation and risk management. It is also slowly influencing the way that certain investors are thinking about correlations, volatility, guidelines and benchmarks.
These changes can be particularly pronounced in situations where markets transition from a mean-reverting paradigm to one of multiple equilibria and path dependency. This is the world in which expectations can and do play a major role in economic and market outcomes.
On the negative side, the global economy saw this dramatically back in 2008-09, and Europe has been experiencing it more recently. Moreover, it featured in many of the historic bubbles and bank runs that are still the subject of analysis and fascination. On the positive end, it has characterized the beneficial breakout phase in several emerging economies. We also saw it in the reactions of markets to circuit breakers imposed by decisive policy actions on the part of several countries in 2009.
In such cases, successful investors (as well as policy makers, researchers and opinion leaders) have to extend well beyond their understanding of fundamentals, historic risk premia, correlations and relative value. They have no alternative but to also try to understand the expectation formation process itself, including agent signaling and feedback loops incorporating economic outcomes and incentive structures. Without such understanding, it becomes even harder to continuously succeed in meeting objectives – especially in a world that will continue to de-lever and where policy makers are still in full experimentation mode.
Both theory and the experience of the last few years suggest that investors must also enhance their analysis of policy makers’ reaction function. Indeed, this is an important input into assessments of correlations, volatility, returns and risk.
For policy, this points to a need for a better design and use of ex ante and ex post circuit breakers. The former prevent the evolution of structures that amplify the feedback loops. The latter are designed to break the serial contamination of expectations, the real economy and market linkages, thereby interrupting the often disruptive dynamic that leads to a sequence of bad equilibria.

A “risk free” asset refers to an asset which in theory has a certain future return. U.S. Treasuries are typically perceived to be the “risk free” asset because they are backed by the U.S. government. All investments contain risk and may lose value.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.

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Beyond Risk-on/Risk-off: Paying Heed to Peripheral Cues in Portfolio Construction

Friday, March 9th, 2012

 

Beyond Risk-on/Risk-off:
Paying Heed to Peripheral Cues in Portfolio Construction

by Vineer Bhansali, PIMCO

  • The availability of high-frequency information, technological advances in electronic trading and the dominance of government and regulatory policy factors made the world since the crisis of 2008 a risk-on/risk-off environment.
  • In January 2012, S&P 500 implied correlations began to fall. It appears that stocks are beginning to take a bit more of their individuality back so that other assets don’t move in lock step.
  • Investors may benefit from a focus on policymakers, relative value opportunities, hedging potential left tail events, and diversification.

This article was originally published in Pensions & Investments online, www.pionline.com, on 5 March 2012.

A fascinating fact whether you are a tennis fan or not: The time it takes for a professional player to perceive, process and respond to a serve from another player is longer than the time it takes for the ball to travel the distance from the server to the receiver.

How can a player return a serve when it takes a longer time to process the information than it takes for the event to happen? Put another way: How do you return a serve that you can’t really even see? (My own response time after a long day’s work is close to 250 milliseconds – try your own hand at a site Humanbenchmark.com – so I would miss a pro-level serve every time, guaranteed.)

The answer in large part is about anticipatory cues. Via many years of practice, a pro learns how to “read” the slightest variations in foot placement, ball toss – even head movement – to position and start to react in advance of the actual serve. Paying attention to peripheral indications and patterns of behavior of an opponent is a well-tested way to improve reaction time and get ahead of the actual event.

Can anticipatory cues help investors? We believe the answer is yes if you know how to watch for them and then use the cues to guide portfolio construction.

Some scene setting is in order: Market participants have access to much of the same information, especially in highly efficient and liquid markets. The availability of high-frequency information, technological advances in electronic trading and the dominance of government and regulatory policy factors made the world since the crisis of 2008 a “risk-on/risk-off” environment in which high correlations between asset classes are seen at times of market turmoil. In such a world, the ability to time betas – i.e., exposures to systematic risk factors – can be more important than security selection. But the peripheral information – the “signal in the noise” – is where the cues are.

In Figure 1, we see that the implied correlation of stocks in the S&P 500 rose for most of last year, but beginning in January of this year correlations began to fall. It appears that stocks are beginning to take a bit more of their individuality back so that other assets don’t move in lock step. It is no surprise that this fall in correlations is accompanied by falling volatility across the board, especially for indices such as the S&P 500.


We have seen correlations fall across and within most other asset classes, too, as the world romances a recovery and falling macroeconomic volatility. Investors slowly, tentatively seem to be taking on a little bit of idiosyncratic risk, as illustrated by falling correlations between certain issuers in the credit markets. (Whether or not this is a good thing remains to be seen.)

So if an investor is aware of the peripheral cues of falling correlations across some important asset classes and risk factors, can he or she then position to make important decisions for portfolio construction?

1. Pay attention to the signals sent by policymakers: Like the tennis server, the gentle opponents of the market participant today are central banks, policymakers and regulators. Their cues, such as liquidity provisions, selection of particular entities (nations and banks) as survivors or failures, are important cues on where the ball will go. More critically, changing signals in the language of pre-commitment to low rates for the next few years (latest Fed extension is to 2014) will provide the necessary cue to reposition portfolios for a higher rate environment. If policy risk factors end up receding into the background, low correlations could become more the norm.

2. Continue to focus on relative value: If correlations continue to fall, participants will likely gravitate towards alpha opportunities, i.e. opportunities that are not simply bets on the direction of systemic risk factors. Relative value opportunities across assets and within assets will likely begin to drive investment returns rather than beta. Market timing will become less important than doing your homework on valuation. Active and smart-passive management that uses security selection expertise will likely beat out pure-passive management in an environment full of relative value opportunities.

3. Hedge Tails: Falling correlations can turn on a dime if there is an accident. In a multi-modal world, markets and participants are exposed to accidents without warning. Lower correlations across assets can turn higher and without warning. Given the low levels of volatility and implied correlations, it has become much less expensive to hedge the fat left tails using systemic hedges. One eye on alpha and one eye on cutting the left tails could add up to much better peripheral vision than both eyes on beta.

4. Diversify: When correlations are high, it is hard to find diversifying assets. When correlations fall, the innate differences in securities allows the free-lunch offered by diversification to work its wonders by providing more optimal mixes of assets. This may result in lower risk for the same expected portfolio return, or higher return for the same expected risk. However, to do diversification properly one needs to focus on the underlying risk factors, not simply on the assets.

The importance of paying attention to cues such as the ones discussed here, however crude, may allow one to get ahead of the pack. These cues provide a powerful set of tools for the creation of more robust portfolios designed to handle today’s market uncertainties, while taking advantage of the possible turning tide of investment opportunities.

Disclaimer
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.
The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The CBOE S&P 500 Implied Correlation Index is the first widely disseminated, market-based estimate of the average correlation of the stocks that comprise the S&P 500 Index (SPX). Using SPX options prices, together with the prices of options on the 50 largest stocks in the S&P 500 Index, the CBOE S&P 500 Implied Correlation Index offers insight into the relative cost of SPX options compared to the price of options on individual stocks that comprise the S&P 500. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. This material is published by Pensions & Investments, www.pionline.com. Date of original publication 3/5/2012.

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Golden Boy: Paul Brodsky on Warren Buffett

Tuesday, February 28th, 2012

Warren Buffett deserves the public’s respect. His great success and apparent modesty, kindness and reason in a field replete with promoters and chest thumpers have allowed him to stand out in our society. He is to most an honest broker among charlatans, uniquely capable of separating truth from fiction, the way it is and will always be versus cockeyed theories touted by ignorant newbies. He has been the most successful and most charitable financier of the last hundred years, and his proclamations become, ipso facto, the common perception of truth.

Buffett may be a sage, a wizard, and an oracle when it comes to nominal relative value pricing of financial assets, but it is well worth noting that Buffett’s proclamations are not necessarily worthy of being considered “fact” in matters unrelated to finance, just as the legendary Joe Paterno’s judgment seems to have been sorely lacking when it came to sorting out matters unrelated to a winning football program.

That has not seemed to stop Mr. Buffett from expressing wide ranging views from tax policy to the value of gold. In fact, over the last two weeks — in a Forbes interview, in Berkshire Hathaway’s annual report and this morning on CNBC — Buffett chose to comment on gold even though he does not have a publicly disclosed position in it. We must assume his aggressive gold comments have been meant to force the price of gold lower. (We do not know why he is so interested in doing so though we do have a reasonable theory, for another time). We strongly disagree with Mr. Buffett’s views and we thought it would be best to explore his comments and provide our counter-arguments.

Productive Assets vs. True Savings

The crux of Buffett’s argument is that he prefers productive assets (procreative, he calls them) and that gold is not one. This implies correctly that gold is a form of savings. Regrettably, the rest of his argument relies on confusing the two, which leads him to two-dimensional logic that clearly fails in practical terms.

We would share Buffett’s preference for productive assets in a Utopian world where money was scarce and credit was funded exclusively with organic savings. In such a world simply depositing our savings in a bank would pass-on our capital to productive businesses that would in turn earn the productive return, all while we (the saver) would retain the risk. That would be a great deal for the bank and the producer but a lousy deal for the saver.

Such a warning to savers (gold holders) is a ridiculous position to take, however, in the context of our modern global monetary system characterized by over-levered currency and unreserved bank credit. Though Buffett is correct that saving in the form of incessantly inflating fiat currency is a fool’s game today, he is dangerously wrong in not seeing that exchanging fiat currency for financial assets and businesses with egregiously inflated enterprise values, (via the egregiously inflated and inflating currencies in which they are denominated), is not equally foolish.

Warren Buffett’s argument against gold falls woefully short of the mark because he does not acknowledge that there is always a role for robust savings wherein the saver neither suffers the dilutionary pain of fiat currency devaluation nor the deflationary pain of acquiring over-levered assets. The medium that allows the true saver to escape both trap doors is gold. It is simply a form of savings that cannot be diluted and the nominal prices of all things leveraged (including financial assets) will revolve around it and other scarce, unlevered items.

Within this context, we re-print and rebut Mr. Buffett’s specific observations related to gold from Berkshire’s annual report, below:

Buffet:

“…the second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.”

QB:

Gold is not an asset and is not meant to be procreative. Above all else it is a currency, like US dollars, and its daily spot pricing reflects its exchange rates with currencies currently being issued by global central banks on behalf of their host governments and used as media of exchange. Gold is not currently a medium of exchange (although to some people it remains a store of purchasing power vis-à-vis other currencies currently in use as exchange media). Thus, in today’s fiat monetary system gold is simply potential money and its spot price indicates the degree to which global wealth holders are willing to handicap the possibility that the future purchasing power of central bank-issued currency will be diluted against it.

Gold is no more or less “lifeless” than Dollars, Euros or Yen. One needs to lend each in order to have a return on them. (We argue one would be foolish to lend gold and receive interest denominated in other currencies when gold is relatively scarce — and getting scarcer — to them.) As for being “not of much use”, yes gold is pretty useless…until it isn’t.

Mr. Buffet is wrong when he implies gold is a bubble (like Tulips). In fact, in spite of all the noise there is very little sponsorship of gold today relative to financial assets. As indicators, the value of the world’s largest gold ETF is one-fifth the market capitalization of Apple, and total precious metal exposure represents just 0.15% of global pension assets.

Mr. Buffet is again wrong in arguing gold needs more avid buyers to keep the bubble inflating. It does not, and in fact we think it is unlikely there will be many buyers relative to financial asset holders as time goes on. Rather, we believe the price of gold will increase in fiat terms with or without widespread secondary market endorsement precisely because central banks must increase their monetary bases to de-lever their banking systems, which in turn de-values the currencies in which leverage is denominated.

Paper claims on gold, such as futures, swaps and dubiously-backed ETFs, will fluctuate with the changing sentiment of financial asset investors until, one day, for some reason that cannot be predicted, claim holders begin to demand physical bullion. All it will take to trigger “a run” will be more demand for physical bullion than the amount available on-hand for delivery. When this happens there will not be a “reasonable” price at which an exchange can be made. Spot pricing will cease to exist and all paper claims on gold will settle in brokerage accounts at the price of the last spot trade. We think very few committed financial asset investors will own gold in any size at the precise moment they will need it most.

Those that do hold physical gold (or shares in gold miners) would be able to then set the exchange rate to fiat currencies (gold price) at which they would part with their bullion. Any externalities, such as government intervention or price controls that would serve to try to set the exchange rate at a lower-than-market rate, would likely be met with indifference among bullion holders and miner shareholders. So yes, Mr. Buffet may be correct that an ounce of gold will always be only an ounce of gold, but he does not seem to be considering its exchange rate.

Buffet:

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

As “bandwagon” investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

QB:

The great bubble from 1981 to 2006 was in unreserved global credit distribution, which explains the funding behind Mr. Buffett’s market psychology discussion. The current bubble is in global base money printing, which has risen over 200% just since 2008 and must increase five times more from current levels to cover unreserved bank assets. Financial assets are the direct beneficiary of credit expansion and real assets are the direct beneficiary of base money expansion. Gold is simply responding to the bubble policy makers are administering. We believe gold is the most under-valued and most optimal risk-adjusted hedge against the current bubble.

Buffett:

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).

Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”

QB:

As we’ve written in the past, our preferred piles (we call them “buckets”) are these: Bucket A is the stock of money and Bucket B is the value of all things not money. At any given point of measurement the value of Bucket A must equal the value of Bucket B. Thus, the debate reduces to “what is money?” If one presumes that fiat currencies and unreserved bank credit have no marginal cost of production (electronic ones and zeros), then their terminal value in exchange must be zero. This leaves gold in the money bucket to assume the value of all things not money. Mr. Buffet again misidentified gold as an asset, not as money.

Summary

We think it is imprudent to advise legitimate savers to invest in levered financial assets. The extraordinary relative wealth one may have amassed over the last forty years in the financial markets was most likely legitimized by nominal scale that cannot be sustained in real terms. Such beneficiaries of leverage and inflation typically built very little sustainable capital and innovated nothing. The largest beneficiaries of leverage and inflation had a near infinite funding advantage, either near zero-rate short-term fiat currency funding or very low term funding. Insurers like Berkshire could effectively divert wages from their country’s factors of production (by charging insurance premiums) and reinvest those wages by providing financing to businesses that would maintain their pricing power (through strong branding or demand inelasticity). That great funding advantage is now gone and Mr. Buffett does not seem too happy about it.

The narrow gap separating wage growth and asset price growth had to widen following the demise of Bretton Woods. Mr. Buffett may have known about this opportunity earlier and better than almost anyone else because his father, (Howard Buffett, US Congressman from Nebraska), was outspoken in aggressively supporting gold and a fixed exchange currency system. It would be counterproductive and beyond our area of study to try to understand what psychological impulse might compel Mr. Buffett to pursue and achieve lifelong financial success in a manner directly contrary to his father’s views on the value of gold and paper currencies. So we can only guess whether his astounding success in consistently positioning a leveraged inflation portfolio has been the result of a sound pre-meditated strategy passed down from his father or has merely been very ironic.

Mr. Buffett’s motivations are not important. He is rich and we think he will always be rich in relative terms because most wealth holders will remain committed to financial assets. Nevertheless, we suspect Mr. Buffet is aware that his wealth is about to be greatly devalued in real terms, just as he correctly foresaw the fate of dot-com billionaires who held their outlets for unreserved credit too long (in the form of corporate shares). Further, we think Mr. Buffett must be aware that the procreative assets he touts are currently priced at multiples of their future nominal cash flows and discounted for almost 0% interest rates, ensuring their future purchasing power will be destroyed in an inflationary environment no matter how much revenue growth they produce.

We believe true savers across the world not beholden to Western financial assets understand or will soon understand the difference between relative nominal returns and absolute real returns. They do (or will) not care about the views of very successful leveraged money changers. Yes, an inert rock today will be an inert rock tomorrow. But it will be an even scarcer inert rock tomorrow relative to the fiat currency in which it is priced (same for fine art). Levered productive assets will lose their value against both unlevered scarce inert rocks and unlevered inelastic commodities. The only things they will outperform in a period of great monetary inflation are bonds and cash (both also levered).

Mr. Buffett is no doubt brilliant but we respectfully disagree with his sense of real value. We find inspiration in the good sense and graciousness of Sir John Templeton who became fabulously wealthy investing in capital building enterprises and always seemed to maintain an objective and flexible investment perspective.

Kind regards,

Lee Quaintance & Paul Brodsky
pbrodsky@qbamco.com

(h/t: Barry Ritholtz, The Big Picture)

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Secular Outlook: Implications for Investors (PIMCO)

Wednesday, July 20th, 2011

Secular Outlook: Implications for Investors

by William R. Benz, PIMCO

​As the lines between interest rate and credit risk become blurred, finding sources of “safe spread” becomes even more critical – with investments based on traditional, broad sector classifications worthy of review.

At PIMCO, we believe more, not less, discretion is warranted when trying to navigate volatile global markets, avoid sectors affected by financial repression and hedge against inflation and/or adverse tail events.

Diversification is still as important as ever, but we believe investors need to look at risk factors rather than traditional asset classes when making asset allocation decisions.

To meet the challenges ahead, investors should rethink “risk-free” and “risky,” interest rate and credit risk, investment guidelines, investment benchmarks and asset allocation in their investment portfolios.

If we talk a lot about our secular (three- to five-year) outlook, it is because we feel it’s really important. First and foremost, it forms the cornerstone of our investment process and provides the key structural themes behind our cyclical positioning and bottom-up, relative value strategies in our clients’ portfolios. Our longer-term views also drive our business strategy, helping us to better anticipate and prepare for the changing needs of our clients. We believe there are wider implications for investors as well, not just in terms of strategic investment positioning but in broader positioning of investment portfolios.

We can sum up our secular outlook as follows: a world operating at multiple speeds, with relative strength in the emerging economies vs. worsening debt dynamics in the developed countries; growing income inequalities; political polarization, financial repression (i.e., governments seeking to impose negative real rates of return on savers) and experimental policy measures; continued bumps and fat tail risks; and a prolonged period of low or potentially negative real returns. We believe getting the proper investment positioning in this type of environment is critical.

Proper business positioning is also important. We have seen a movement toward more bespoke “outcome-oriented” solutions in recent years – ranging from absolute return to yield, income, liability matching, inflation protection, tail risk hedging and “smart” beta using improved benchmarks – with the current secular environment likely to only further the trend. This need for outcome-oriented solutions is the key driver behind PIMCO’s evolution beyond fixed income into asset allocation and other asset classes, including active equities. It informs other parts of our business strategy as well, such as our plans for more local talent resourcing and an even greater emphasis on providing solutions.

As for the broader investment implications, we have identified five main areas that we believe will continue to challenge conventional wisdom and historical precedent, compelling investors to rethink their traditional approach to managing and positioning their investment portfolios.

Implication #1 – Rethink ‘risk-free’ and ‘risky’
If you were asked three years ago to identify which two countries with similar economic fundamentals and initial conditions– Spain or Brazil –carried a greater degree of sovereign risk, you would probably have said Brazil without much hesitation. Spain, as part of the European Union supported by wider European policy measures, would surely have been considered “risk-free” – or at least relatively low risk. Brazil, on the other hand, as an emerging market country, would surely have been considered “risky” – at least relative to Spain. But fast-forward to today and most people would say the opposite – that Spain is clearly risky and Brazil, while not risk-free, certainly appears less risky than Spain and many other sovereigns. This is pointedly reflected in current credit default swap (CDS) spreads where the cost of buying protection for Spain today is dramatically higher than it was going into the eurozone sovereign crisis (see Figure 1).

The onset of the eurozone crisis has certainly caused investors to rethink the concepts of risk-free and risky. And with the continued deterioration of developed sovereign balance sheets – including that of the U.S. – this will likely be an even more important issue going forward. In other words, sovereign analysis matters.

Implication #2 – Rethink interest rate and credit risk
Tradition says that emerging market economies have historically been associated with credit risk while developed countries have been associated with interest rate risk. But that distinction is becoming muddled as a growing number of developed economies, especially in the eurozone, are saddled with larger debt burdens and weaker sovereign balance sheets, while emerging market economies continue to exhibit stronger fundamentals. This is best exemplified by Spain, or even more so Greece, vs. Brazil. But there are many other examples on both sides, with perhaps the most striking being the U.S. now under threat of a credit downgrade.

As a firm, we have been de-emphasizing interest rate risk in favor of credit risk and other potential sources of “safe spread” within our clients’ portfolios. PIMCO defines “safe spread” as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios, given the range of risks. These are securities backed by strong balance sheets and/or high-quality collateral, which we view as being less susceptible to financial repression, policy mistakes and tail events, and which provide additional yield over core (e.g., German, U.S., U.K.) government bonds. Investment grade corporate bonds of issuers with strong balance sheets, high-quality asset- and mortgage-backed securities and covered bonds form the bulk of our “safe spread” holdings. But higher quality emerging market bonds – both hard and local currency – as well as select shorter-maturity high yield bonds are also attractive in our view.

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Investors Turning to Active Commodities Strategies?

Thursday, May 19th, 2011

by Leo Kolivakis, Pension Pulse

Via Pension Pulse.

I hooked up for lunch with commodity relative value fund manager I spoke to on Monday. He’s looking to raise raise capital for this new fund which he will be managing with other experienced traders and we went through his pitch book.

I’ve sat with some of the best hedge fund managers in the world. The best of the best know the theory but more importantly, they can give you tons of examples of actual trades that went for and against them. That’s exactly how this manager presented his views. He has the academic and industry credentials, but it’s his actual commodity trading experience in Canada and the US that came through as he walked me through one trading example after another.

I love talented alpha managers. I’ll repeat what I’ve been stating the last few posts, there is exceptional alpha talent in Quebec that is being underutilized or worse still, totally ignored. I met two of Montreal’s best hedge fund managers today and I wouldn’t bat an eyelash to invest in either one of them (the other is an equity market neutral manager).

The question I get from outside-Quebec investors is if they’re so good how come the Caisse and other large Quebec institutions don’t invest in these new and existing hedge funds? There are a lot of reasons. First, reputation risk. There have been quite a few scandals in Quebec with institutions getting burned with funds like Lancer, Norshield, Norbourg, and other frauds. The last thing any institution here needs is to read that some hedge fund they invested with blew up, especially if it’s a local fund (the media in Quebec are merciless).

Second, unlike other places, Quebec lacks the entrepreneurial drive to develop the absolute return industry here in Montreal. There entrepreneurs and visionaries like Jean-Guy Desjardins over at Fiera Sceptre who are trying hard to change this. His fund runs both long-only and a good size equity market neutral fund.

But no matter how smart and successful Jean-Guy Desjardins is, he cannot change Quebec’s absolute return landscape by himself. Quebec institutions like the Caisse, the FTQ, Desjardins, and the National Bank have to do a lot more to develop alpha talent within and outside their organization (Ontario Teachers’ has seeded a few Ontario hedge funds and funds of funds).

At one point, Desjardins Asset Management had the largest fund of funds in Canada, but after the crisis they shut that operation down, cutting it at the worst possible time (terrible business decision and way too conservative risk management). Unfortunately, even when they were big, they hardly seeded any Quebec hedge fund and mostly invested in managers based out of New York and London.

There is this misconception out there that managers from New York and London are better. The commodity arbitrage manager explained it to me like this since he worked in both countries: “There are more CFAs per capita here in Montreal who understand theory well, but they lack money management experience. If you go to New York, there are a lot of good traders but they’re not brighter than our investment managers”.

Another prominent Quebecer who worked in both countries explained it to me like this: “Any bozo could open a hedge fund in New York. Lots of slick Wall Street salesmen who lost their jobs after the crisis were able to raise millions and start a hedge fund. That’s why a lot of hedge funds suck and charge alpha fees for beta (we were discussing the Bridgewater paper, selling beta as apha).

That’s another topic that I raised with this commodity arbitrage manager. How many bozos are able to make a lot of money in this business either because they can bullshit their way into a position or they’re purely lucky and ride the wave for as long as they can. One of the smartest and nicest guys I know in this business works with the Fixed Income group at the Caisse and I can assure you he’s not getting compensated anywhere close to what many bozos in finance are getting paid. That’s what pisses me off about our business, too many snake oil peddlers are getting away with murder and getting paid way too much money while smart people get shafted.

And don’t get me started on brokers. Most of them are pure financial whores who’ll do anything to squeeze a buck out of their clients. There are excellent brokers, people who offer fantastic, actionable ideas, but they’re a dying breed. That commodity arbitrage manager told me: “I don’t shop around trading ideas. I reward brokers who offer me good insight, and trade with them even if they’re more expensive.” That’s the way it should be, reward the brokers who offer you the best ideas.

We started discussing passive commodity indexes, and I told him I don’t believe in them. Some of the larger ones are all about energy and even the ones that are more diversified are way too volatile to justify a sizable allocation. Moreover, the diversification benefits of these passive commodity indexes are exaggerated, and most of the returns can be explained by rebalancing and roll yield.

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Is High Yield the place to be?

Friday, June 25th, 2010

This article is a guest contribution by Econompic Data.

Professor Pinch (hat tip Abnormal Returns) discusses the remarkable performance of high yield corporate issuers:

According to Fitch, the high yield default rate went from 13.7% with 151 defaulters last year, to a forecasted 1% default rate for this year.

His theory why:

My theory is interest expenses have taken such a dramatic cliff-dive it has only served to help high yield companies in managing interest costs and as a result their weighted average cost of capital.

In other words, low interest rates are allowing [even] zombie corporations to stick around (i.e. their business models may be dead, the economic environment may be dead, but low financing costs allow them to remain “alive”). But why would someone invest in a company that just a living dead entity. Bloomberg details:

“High yield is the place to be,” said Manny Labrinos, a money manager at Nuveen Investment Management who oversees $1.8 billion of fixed-income assets. “Sub-par growth is somewhat of a Goldilocks scenario because it means rates stay low and people are still going to reach for yield.”

Investors are willing to take the risk due to the perceived relative value of high yield issuers. The below shows the yield to worst “YTW” of the high yield index vs. the five year treasury yield (the durations of the two are similar, thus the comparison).

This second chart is the ratio between the two. What it shows is the years to yield “YTY” (this type of metric is typically used to value muni bonds) to see how many years of treasury interest high yield bonds are currently yielding (or the more simple explanation, the ratio between the two).

With a yield to worst of 9% vs. just 1.9% for a 5 year treasury bond (or 4.8x more than similar duration Treasuries) we can see the appeal of the investment, but can they remain “alive”.

Source: Barclays Capital

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