This is the first of two white papers to be published by our Chief Investment Officer, Henry Maxey, on the current investment climate and where we see the risks. The second paper, Dismantling the deflation machine, will be published in March 2020.
The epicentre of risk in the financial system has moved. In 2008, it was leverage in the banks. Today, the equivalent risk is in the asset management industry, where a series of interlocking factors have come together to make markets increasingly ‘avalanche prone’. There is an illusion of stability. Low volatility has lulled many to sleep. We believe this will end badly – and are positioning portfolios to protect our clients from the avalanche.
A decade of emergency monetary policy – quantitative easing, zero and negative interest rates – has distorted behaviour and perspectives. Risk is widely underestimated. If you assess a portfolio’s risk through the prism of volatility – a prism distorted by the actions of central banks – then you will be underestimating risk as monetary policy is tightened and liquidity is withdrawn from the system.
There are a multitude of slightly distorting factors that make the financial system fragile, not a single perpetrator. The art is to understand the interactions. So far these interactions have played out so the factors reinforce each other, supporting the illusion of stability. This positive feedback loop could easily reverse though, and reinforce in the opposite direction, shattering the illusion.
Alternatively, a summary of key points are as follows.
1 Nominal returns drive behaviour
Savers and investors tend to think in nominal terms as opposed to real (after inflation) returns. The cause is both contractual and behavioural. Contractual, because many institutional investors, such as pension funds, have nominal return targets for their portfolios. Behavioural, because of psychological biases such as reference dependence (we get used to a particular level of income from our savings, and we try to preserve the level when interest rates fall), and salience (nominal returns are visible, while real returns are not, and we tend to work off what we can see). This means the risk-taking behaviour of investors and savers increases non-linearly as nominal interest rates tend to zero. The more extreme monetary policy becomes, and the longer it remains in that state, the more people move up the risk spectrum and down the liquidity spectrum. We see this through the increased allocations of institutional investors to illiquid alternative assets such as private equity and private debt.
2 Role of bonds in portfolios
The effect of a deflation-biased system has been to make bonds a very effective offset in portfolios, because bond and equity prices become negatively correlated. In effect, bonds have behaved like positive-carry equity put options. This encourages leverage, as we see in investment strategies such as risk parity. If the regime were to cease to be biased to deflation, bonds would become a less attractive portfolio asset. The measured risk – ie the volatility – of portfolios would increase, encouraging investors to de-risk and/or deleverage.
3 Regulation and liquidity
Capital and liquidity regulations have been designed to make sure banks can withstand stressed markets. This has reduced their capacity as market makers, leaving asset management as the key marginal actor. Because asset managers don’t have the same degree of flexibility as banks – they are constrained by the investment mandate, which is increasingly a passive one – the ability of the system as a whole to accommodate material changes in asset allocation shrinks. Liquidity mismatches between a fund’s terms and its underlying assets exacerbate this problem.
4 Rise of quant-based investing
Simply put, investor’s enhanced ability to analyse data (which is, necessarily, only the past and the present) inspire investing strategies which assume past patterns and correlations will be repeated. Regime changes confound past patterns, and a new regime takes time to be incorporated into trading models.
5 Rising share of passive investing
As all asset prices have risen, the shift to low-fee passive vehicles has accelerated. The effect of this shift is that beyond a certain threshold – circa 50%, it seems – investment flows matter more than fundamentals in determining price.
6 Risk premia investing and volatility
When expected nominal returns are low, small but persistent risk premia become very attractive. Consider investors seeking to harvest the volatility risk premium. My view? It is dangerous for volatility to be an asset class and, simultaneously, a measure of risk for most of the asset management industry.
7 Embedded leverage
The current regime has encouraged financial engineering, from debt-financed share buybacks to ratings-optimised Collateralised Loan Obligations. This raises the sensitivity of asset prices to changes in the operating environment.
8 Gap risk
Many of the features mentioned above combine to increase the vulnerability of the system to gap risk – a large and immediate fall in asset prices. Gap risks arises because the market is unable to intermediate flows of assets with continuous pricing.
The prudent investor must expect the avalanche, and clamber on to different ground – a ground where real protection costs real money and can make real money. Our portfolios are built with the aim of keeping our clients safe, to perform well in a sharp market dislocation, and to allow us to profit for the opportunities a dislocation would bring.
This article originally appeared in the Ruffer Review 2019.
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