Passive Investing, the Debt Cycle and Price Discovery
In early 2021 we published a piece on why we believe the lack of alignment between asset allocators, investment managers and academics on the one hand, and the ultimate owners of capital on the other, has created one of the biggest risks capital markets has ever seen. The negative consequences from this have started playing out before our eyes. The worst is perhaps yet to come, as much of the selling in capital markets has been institutional and hedge fund money, aka the ‘smart’ money. Although, ‘smart’ might be the wrong adjective…but that’s for another discussion!
The point is that retail investors and pension assets have made very little tactical changes in their asset allocation and indeed many remain heavily invested in equities alongside large allocations to fixed income as a ‘diversifier’.
“Show me the incentive, and I will show you the outcome.”
Charlie Munger, vice-Chairman, Berkshire Hathaway
Trends over the last two decades, high fees for ‘active strategies’ along with better transparency and ease of access, have driven trillions into passive index tracking funds… justifiably so. General scepticism about the benefits of active management has been driven by “active managers” over-charging clients for sub-par, over-diversified, closet-tracking investment strategies. The biggest culprit however has been the lack of alignment, the misaligned incentive, behind asset allocators and academia, compounded by poor manager selection and bad execution.
Chart 1: Cumulative flows to domestic equity mutual funds and net share issuance of index domestic equity ETFs, billions of dollars, monthly
“The stock market is filled with individuals who know the price of everything, but the value of nothing.” –Phillip Fisher, US investor and author of ‘Common Stocks and Uncommon Profits’
Harry Markowitz’s Modern Portfolio Theory (MPT) formalised the benefits of diversification and validated a backward-looking measure – volatility or standard deviation – as an accurate measure of investment risk. Find two assets whose prices have behaved differently in recent history, put them together and voila – you have just reduced your investment risk. By repeating the process, you create what is known as the efficient frontier. In 1958 James Tobin added the risk-free rate to MPT and introduced the Capital Markets Line (those portfolios that combine the efficient frontier with the risk-free asset) along with the concept of leverage. Extrapolate these theories and we can reduce risk by adding more assets, and then increase returns by levering up any efficient portfolio.
In the 1960’s the efficient market hypothesis gained prominence, in part because of the emergence of computers. Whilst the work of Daniel Kahneman and others on behavioural finance have shown that markets are anything but efficient, a different human behaviour managed to trump all others…laziness!
Rather than doing better research and fundamental analysis to understand the value of an asset, many investors and portfolio managers have taken to these theories of volatility as a measure of risk, and diversification as a tool to mitigate it. The consequences have played out ever since: over-diversification and ‘relative’ risk management, which have led to sub-par returns. As the below chart shows, on average only 43% of fund managers have managed to outperform the S&P 500, over the 46 years between 1975 and 2021.
Chart 2: % of Managers that outperform the S&P 500 over a rolling 5 year basis
“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”
Warren Buffett, Chairman, Berkshire Hathaway
Gatekeepers, fund selectors and institutional asset allocators have been allowed to avoid career risk, by passing on any investment risk. A quote often laughed at within the fund selector universe – although all too frequently true – is: “no one has ever been fired for selecting Blackrock”. A manager underperforming for two or three straight years will probably not survive the next analyst review or Investment Committee meeting. As a result, these gatekeepers have been able to lower the cost and the “relative” risk for the owners of the capital, by embracing indexation. At the same time, they’ve been able to pass on career risk in a cosy, probably overpaid, job!
A very good piece of analysis in a paper in the Financial Analyst Journal a few years back, sought to identify the factors behind active management which are material to returns. The evidence from this white paper showed that, statistically, you are significantly more likely to outperform if:
- You employ a high conviction, concentrated, benchmark-agnostic approach, and
- You have a long holding period and low turnover
The caveat is that the research looks at active management returns over a rolling 5-year period, and not 1- or 3-year data. However, conforming to these two characteristics has resulted in an average annualised excess return of more than 2% per annum over the long term. As such, it’s not unrealistic to assume that the average manager follows neither a high conviction nor a long-term investment approach. Perhaps they did, but they’ve either been fired, or they saw the opportunity in ‘closet-tracking’.
Higher volatility does not mean more downside risk, nor does it mean higher return. Below is a small sample set of selected equity indices, highlighting their returns, standard deviation and maximum drawdown over the last 25+ years.
Table 1: Long Term Total Returns of selected indices, 06/1995 to 08/2022
Whilst none of them have any material stock specific risk, the key takeaways are:
- More diversification does not imply lower volatility,
- Lower volatility does not imply lower drawdowns,
- Higher volatility does not imply higher returns, and
Adding these together, leads to two crucial conclusions:
- Volatility alone is not suitable to measure risk, and
- The question is perhaps not about ‘value’ or ‘growth’, but more about ‘conviction’ and ‘duration’.
Investing requires a forward-looking perspective, and whilst strategies that rely on backward looking data might deliver “sufficient” results for a period of time, most quantitative investors will know “it works, until it doesn’t”. Backward looking strategies, by design, are unable to accommodate significant changes in the underlying trends. Paradigm shifts. There are two significant trends that have dominated financial markets in recent history:
- The ever-rising levels of debt, and
- The collapse in the cost of capital
The latter we believe has come to an end. Whilst politicians might not believe it, central bankers have come to the realisation that money cannot be free. But before we touch on these, let’s look at price-discovery and how it’s been impacted by the rise of indexation.
“A shortage is a sign that somebody is keeping the price artificially lower than it would be if supply and demand were allowed to operate freely.”
Thomas Sowell, American author, economist, and social theorist
The opposite of the above quote is necessarily true as well. Think about liquidity (abundant) and bond market valuations over the last decade (artificially high). Looking back at history, it’s clear to me that credit is the backbone of capitalism and central bankers are the brain (the IQ level is up for debate!). Monetary policy over the last decade has resulted in an abundance of liquidity and artificially low interest rates. Low interest rates or low yields, directly infers high price. But the artificial nature behind it means the supply-demand dynamic is not sustainable, a bit like a coiled spring.
Taking a step back, a crucial characteristic behind free-market-capitalism, is the idea of price discovery. The idea that an asset will exchange hands at a level where supply meets demand. A stock exchange facilitates not only this exchange of the underlying asset, but crucially provides a marketplace where this price can be agreed upon, without (thanks to the internet) having a tedious discussion about the value of the asset. The more participants in the market, the more liquid the market becomes, and the more efficient the underlying price discovery.
In an actively managed strategy, a security considered by a portfolio manager as over-valued is sold, and the proceeds are used to buy a security the portfolio manager considers undervalued. In practice, he will exchange one asset for another. The portfolio managers in the market, will continually buy and sell these securities from and to each other. The managers with a strategy that has a sustainable competitive advantage, will – in aggregate over time – buy shares at a lower price and sell them at a higher price compared to managers that do not have a sustainable competitive advantage. As highlighted above, whilst “value” or “growth” can be a philosophy, it is not a sustainable competitive advantage. Conviction and duration, however, have been identified as characteristics that might be just that!
Of course, it is possible for one of the participants in the market to buy and sell assets with no regard for the fundamental value. They might only provide liquidity – a valuable characteristic – or they might just follow an investment policy. The latter might seem obscure – who on earth follows an investment policy without any regard for the underlying fundamental value? How can it even be termed an “investment policy”?
Well, this is where we enter the era of indexation. Whilst there are clearly benefits to indexation, significant risks will arise when the index tracking investment manager (they can collectively be seen as one, since they are in no way differentiated) becomes a significant part of the underlying market. There is a point in time where the negative consequences will start to feed on itself, price discovery will become obsolete, and liquidity will start to deteriorate. Slowly but surely market fundamentals will become neglected, and a market bubble will start to develop. Even those active managers with a sustainable competitive advantage will struggle as the other side in the exchange are agnostic to what price they pay – they just want to buy! A momentum strategy might do well for a period of time, as the bigger and / or more favoured assets will only get bigger and more favoured. But as mentioned earlier, a traditional backward looking momentum strategy will only work, until it doesn’t. This played out in the late 90’s and has been on a roll again over the last decade. At least until the end of 2021.
“The history of markets is one of overreaction in both directions.”
Peter Bernstein, American economist and historia
In 1959, the US mutual fund industry – all US registered investment companies – was $21bn in size, circa 4% of GDP. At the end of 2021, this industry is $27 trillion US Dollars in size, about 120% of annual US GDP.
Also worth noting, is the amount of corporate debt outstanding. In 1959 credit to non-financial corporations in America stood at $187 billion, or as chart 3 below highlights, about 36% of GDP. At the end of Q1 this year, that level is over 80% of US GDP, or a colossal $19 trillion.
Chart 3: Changes in US corporate debt, in nominal terms and as a percentage of US GDP
This brings us full circle back to the brains of our capitalist system – the central bankers! Zero-interest rates policy (ZIRP) and the collapse in the cost of capital over the last 40 years have resulted in the mother of all bubbles. The backstops that until recently have been provided by central bankers around the world, meant that financial assets reached valuations that were unsustainable, especially in bond markets.
According to the Institute for International Finance, total global debt reached US$305 trillion at the end of March 2022. This has been borrowed from future wealth, as total global GDP in 2021 was less than a third of that. In order to pay-off this debt, the proverbial pie has to grow…we simply have to achieve growth! But in order to do so, the cost of capital cannot be zero. Consequently, interest rates have to go up. However, given the amount of debt outstanding, the consequences of rising rates are…well…potentially catastrophic. The correction we have seen in 2022 is merely the tip of the iceberg!
We said it in early 2021 and will say it again: regime change is necessary. We believe it has started. If the tremors of regime change start to cause cracks in the passive bubble we have created in recent history, we’re in for a rough ride!
As we mentioned in 2021, we are now seeing how rising interest rates are impacting discount rates and how capital markets continue to re-value assets lower. As financial conditions continue to tighten, what might happen when the trillions of dollars in index funds decide to sell? Not only is there perhaps not enough active managers to buy the securities from them (i.e. no liquidity), but the few remaining will probably be unwilling to buy the assets of them because active managers tend to be price sensitive.
“Teach a parrot the terms ‘supply and demand’ and you’ve got an economist.”
Thomas Carlyle, Scottish historian and philosopher
The bubble we created due to the lack of alignment is perhaps the biggest and most misunderstood risk in financial markets today. Whilst not insignificant, index tracking funds are still reasonable when compared to total asset management AUM. However, Blackrock, Vanguard and SSGA collectively have assets under management of over US$20trillion and with index tracking funds making up more and more of daily trading volumes, the risks are significant enough to have a very material impact.
Whilst economists spend their time forecasting inflation or economic growth, many seem to be missing the wood for the trees. Liquidity, the direction of flows and price discovery, are as essential – if not more so – than the variables we plug into our econometric models. Human behaviour, cognitive biases and psychology of capital markets are so much more than a number! As we mentioned in our original letter, this is not so much about being naked when the tide comes in, but more about not getting trampled when everyone runs for the