Saturday, February 28, 2015

Is the Fed Targeting Bond Yields? Mr. Dudley's Conundrum

In the history of ideas, it is always fascinating to observe how certain notions gain traction and overcome opposition. Max Planck famously wrote, "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it." I've always found it a touch optimistic to assume that some form of objective truth always emerges victorious in the marketplace of ideas. We know that isn't the case, with discredited opinions often showing surprising and alarming resilience. Finance and economics are no exceptions to this phenomenon. For example, German hyperinflation is often cited as having led to Hitler's ascent to power, when in reality, it was deflation that brought the Nazis to power, as Matt O' Brien and Lars Christensen point out

Sometimes marketing is important. Certain phrases seem to capture the public imagination, helping ideas spread, for better or worse. I'm often irked by the phrase "Lehman moment", which people often use casually to mean a tipping point in a crisis. Lehman, of course, filed for bankruptcy on Sep 15, 2008. While a massive event, it was just one of many in a significant chain of financial panic. I remember sitting with a fellow junior analyst on Sep 10 or so discussing the momentousness of Fannie and Freddie being put into conservatorship. The failure of the first TARP bill on Sep 29, 2008 also seems to be relatively forgotten in public memory, although that event coincides more closely with the real panic phase of the crisis (The S&P 500 was down about 3% in the 10 trading days between Lehman and the bill failure; it was down about 26% in the 10 trading days after the TARP bill failure). (See chart and data here - hardly conclusive, but worth noting).

But I suspect the real reason I find the phrase "Lehman moment" so chafing is because people often conflate the financial panic with the economic plunge, and ignore a slow Fed response to the crisis. It is surely too much to expect any institution to react perfectly to a crisis given the "fog of war", but I think it's still important to highlight the Fed's missteps. I've done so in a previous post, highlighting how Rick Mishkin's concerns were ignored by his FOMC colleagues

Funnily, most criticism of Fed seems to be encapsulated in another popular phrase, "too low for too long" (TLFTL). TLFTL is of course is the notion that the Fed contributed to financial instability by pursuing an overly accommodating monetary policy prior to the crisis. I don't have a strong view on the matter, seeing arguments in both directions, but it's clear that current Fed policy-makers harbour worries about TLFTL. The Fed has made hawkish noises well in advance of any rate rises, leading to the infamous Taper Tantrum. And more recently, New York Fed President Bill Dudley made the following remarks in a speech:

"One significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levels - for example, the 1-year nominal rate, 9 years forward is about 3 percent currently...If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher."

Let me note that (a) the context of this speech was a generally nuanced discussion of the real interest rate; (b) the speech is generally quite dovish in not wanting to adhere to a strict Taylor rule that would demand a higher Fed funds rate, and (c) Dudley's views do not, of course, represent the FOMC. But I found myself confused: Is the Fed now targeting long-term bond yields? The use of the word "conundrum" seems deliberate. Naturally, this brought to mind Greenspan's use of the word in testimony to Congress describing falling long-term rates despite an increase in the Fed funds rate. Greenspan and Bernanke seemed content before the crisis to explain away the conundrum with the "global savings glut" hypothesis. Post-crisis, however, Dudley, seems much less eager to use that argument. Dudley seems to be saying "The conundrum is back, but this time we'll act differently. TLFTL won't happen again." 

Oddly, research by Daniel Thornton of the St. Louis Fed suggests that the relationship between Fed Funds and long-term yields had broken down by the 1980s. I must confess I don't have the econometric chops to evaluate this research fully. And even more importantly, perhaps I'm over-analyzing this. After all, policy-makers aren't known for inventive language, so Dudley might just be reverting to a familiar phrase. But if Thornton is right, it's disturbing for Dudley to focus on long-term bond yields. If the Fed is swayed by the price action of long-term bonds, combined with a lingering institutional sense of TLFTL guilt, I would be deeply concerned for the global economy and financial markets. I would also expect such a course of action to backfire spectacularly since long-term bond yields would probably decline if the Fed was too hasty in raising rates. But some bad ideas never seem to die - and as we've seen, some of those bad ideas can have painful repercussions for a very long time.

Monday, February 23, 2015

Index Funds: A False God?

The case against active asset management, particularly of equity investments, has many prominent expositors. Warren Buffett, perhaps the greatest known exponent of active management, made the startling remark in 2014 that he wanted his 90% of his estate to be put into a low-cost S&P 500 index fund. A more comprehensive argument is proffered in Swedroe and Berkin's excellent "The Incredible Shrinking Alpha", which is a highly readable summary of the case against active management. Swedroe and Berkin (henceforth S&B) lay out a variety of arguments against active management, which I summarize as follows:

1) Many alpha-generating factors (such as value, small size, momentum and quality) have been identified, so they can now be harnessed more cheaply, and are effectively beta.

2) In a competitive financial environment, successful trading strategies self-destruct. If a clear anomaly is discovered, investors will seek to exploit it, eventually leading to its disappearance. Or to put it more poetically, Lee and Verbrugge write, "The efficient market theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world." 

3) Alpha is a zero-sum game, meaning some investors must exploit the mistakes of others. This is becoming harder as (a) the growth of index funds drives down their costs, increasing their advantage over active funds, and creating a virtuous circle of size, lower fees and better performance; (b) the number of funds has grown, creating far more competition for alpha; (c) the "paradox of skill" means that today's active investors are better trained and have greater resources, making it harder to achieve outlier results; and (d) successful active management creates large inflows, making it difficult to replicate success.

Before proceeding, I must draw a distinction (as S&B do) between passive index funds and passive funds with systematic rules. To simplify matters, I'll refer to these as index funds and systematic funds respectively. 

I'm extremely sympathetic to argument (1). Despite my background as an active investor, I'm quite willing to accept that passive funds with systematic rules can help investors in their search process and mitigate cognitive biases. But I'm far more cautious about index funds, which ironically are seen as simpler for the average investor to understand. 

S&B themselves acknowledge the debt index funds owe to active managers: "Active managers play an important societal role - their actions determine security prices, which in turn determine how capital is allocated. And it is the competition for information that keeps markets highly efficient both in terms of information and capital allocation. Passive investors are "free riders." They receive all the benefits from the role that active managers play in making the financial markets efficient without having to pay their costs. In other words, while the prudent strategy is to be a passive investor, we don't want everyone to draw that conclusion." Essentially, index funds are derivatives of the skill of active managers and steadfastness of systematic funds. But derivatives, the ever quotable Buffett reminded us, are "financial weapons of mass destruction". The history of financial innovation seems to be strewn with examples of legitimate new tools taken to excessive lengths. We may one day think of the well-intentioned index fund in a similar fashion. 

To explain this, I turn to Argument (2), which is broadly true, but occasionally wildly wrong. While markets are generally efficient in the medium term, it doesn't take much financial history to know that sharp periods of deviation from efficiency can occur. S&B appeal to the idea that markets are better information processors than individuals due to the aggregation of collective wisdom. Likening a skilled individual investor to tennis great Roger Federer, they write, "While the competition for Federer is other individual players, the competition for investment managers is the entire market. It would be as if each time Federer stepped on the court, he faced an opponent with Roddick's serve, Murray's backhand, Gonzalez's forehand, Nadal's baseline game, Stepanek's net game and Ferrer's speed." This is a good analogy with one problem: for all its supposed skill, we know that the market occasionally has the temperament of John McEnroe or Marat Safin. While we can agree on general market efficiency, we should not over-sell the principle. Indeed, we need active and systematic funds to act as "stabilizing speculators", to quote Milton Friedman.

This can be seen simply as a rebuttal of the neoclassical EMH model. A timely new paper by the IMF's Brad Jones summarizes current arguments for deviations from the EMH: 

In similar fashion, we can raise some criticisms of index funds.

- Limits to learning: "Markets are particularly vulnerable to bubbles where there is a low level of financial literacy among participants, and common knowledge over the existence of a bubble is absent." (Jones) If investors are plowing money unthinkingly into index funds, they will have no anchor against market turbulence. This is a version of the Standing Ovation Problem, where agents act due to their own beliefs, but also out of mimicry and conformity. S&B make the following argument about active strategies: "When a strategy becomes popular, not only will it have low expected returns due to crowding, but the assets in it are now "weak hands" - the investors who tend to panic at the first sign of trouble. That leads to the worst returns occurring at the worst times, when the correlations of all risky assets move toward one." There is no reason this would not apply to index funds. 

- Frictional limits to arbitrage: "Another source of friction capable of amplifying bubbles stems from the 'captive buying' of securities in momentum-biased market capitalization-weighted financial benchmarks...Importantly, the captive buying phenomena [sic] is unlikely to abate given the (passive) benchmark-tracking exchange traded product industry has expanded at a decade-long annual growth rate of more than 20 percent (to US$2.5 trillion), a much faster rate than for other relatively non-benchmark constrained investors."

- Institutional limits to arbitrage: As index funds become ever more entrenched in the financial mainstream, it may become increasingly difficult for managers to veer from benchmarks despite valuation concerns.

To be clear, I'm not saying that index funds are unambiguously bad or dangerous. Index funds allow investors to gain exposure to equity risk at a low cost. Like any other tool, however, they should be used with care, with a clear understanding of what they represent - an investor's claims on cash flows to an underlying equity piece. S&B have done a wonderful job in bringing together various strands of the case against active management. But investors should be wary of substituting one false god for another.

Thursday, February 5, 2015

Monetary Orbit: Do We Have A Kepler?

David Beckworth has consistently argued that the US is a monetary superpower. He writes, "The Fed has this power because it manages the world's main reserve currency and many emerging markets are formally or informally pegged to the dollar. As a result, its monetary policy gets exported to much of the emerging world. The ECB and Bank of Japan are also influenced by the Fed's decisions because they are careful not to let their currencies become too expensive relative to these dollar-pegged currencies and the dollar itself. U.S. monetary policy, consequently, gets exported to the Eurozone and Japan as well."

This is hardly a recent phenomenon. I've been reading Barry Eichengreen's "Exorbitant Privilege", and it describes (among other things) the international conditions that led to the creation of a European single currency. The Nixon administration is probably most famous in popular consciousness for Watergate and foreign policy actions in Vietnam and China, but its inflationary policies were the the architect of serious change in international monetary arrangements. The threat of dollar devaluation led to capital flows to Germany, upsetting the European balance of competitiveness. "The report of the Werner Committee, issued in October 1970, saw irrevocably locking exchange rates as essential for preservation of the Common Market and as insulating Europe from destabilizing monetary impulses from the United States." The breaking of the dollar's peg to gold proved even more momentous. As Eichengreen notes, "Not for the first time, erratic U.S. policies pushed Europe into monetary cooperation." 

The dollar's power worked in Europe's favour (well, in the short-term, at least) after 1992. "Just as a weak dollar had contributed to Europe's earlier financial difficulties, a strong dollar now relieved them", setting the stage for miffed European partners to make nice and resume the path to monetary union. Eichengreen observes, "There is no little irony in the fact that a strong dollar helped make possible the transition to the euro, given that a weak dollar had regularly provided impetus for Europe to move in this direction." 

Even so, US monetary policy cannot act in isolation. Bernard Connolly's "Rotten Heart of Europe" posits that the Wall Street crash of 1987 was sparked by the Bundesbank raising its official rates in October 1987 for the first time since 1981. Connolly writes "The impact on the other side of the Atlantic was immediate. James Baker denounced [Bundesbank President] Schlesinger for, in his view, jeopardizing the world recovery. Schlesinger replied that German price stability could not be put at risk. US financial markets feared that American interest rates might rise, or at least be prevented from falling. The stock market had been booming while long-term interest rates had been rising, a vulnerable combination. Now, the open conflict between Baker and Schlesinger and the prospect of a long period of high long rates shattered the fragile, misplaced confidence on which the stock-market boom had reposed."

These episodes perfectly capture the nature of the economy as a multi-agent system. This doesn't really simplify matters - see, for example, the difficulty of formulating the current ECB-Greece standoff in game theory terms. In fact, the economy is probably even more complicated than that, better represented as a complex adaptive system, since economic actors are responding to and shaping central bank actions in unpredictable ways. It's a theme I cover a lot, but this view of the economy seems to present a problem for those who deny the importance of a macro framework for their investment processes. Macro changes spread through the economy, without respecting the supposed imperviousness of security selection and fundamental investing. 

But there's an opposite problem, which I cover here a lot as well. Our ability to perceive and foresee change is flawed. But more importantly, the effects of some of these changes are essentially unknowable - that, after all, is one of the challenges of observing a complex adaptive system. In assessing monetary orbit, we may be hard pressed to find a Kepler, much less an Einstein. So what should we do then? One strategy proposed above is to ignore macro change. I don't think that works. Driving without a map seems a silly proposition. But so does building a system that purports to capture the complexity of the real world. 

This sets up a paradox: 

(1) Investors (and policy makers) have to accept they operate in a complex adaptive system, where they will be buffeted by the occasional, unexpected gust of wind. They need to create a framework that incorporates data without fetishizing the veneer of precision. File this along with other paradoxes such as:

(2) Asset markets are occasionally inefficient, allowing nimble investors to scoop up bargains (or harvest risk premia). But investors rely equally on efficient markets: if they were always inefficient, the savvy investor could never (a) determine fair value or (b) recognize a profit by selling at fair value.

(3) Tied to (2), from a behavioural standpoint, this demands that the investor be arrogant enough to believe she has identified a mispricing but humble enough to realize she could be wrong.

This might be enough to make you tear your hair out in frustration, but I plan to cover in a future post some strategies for dealing with these issues, inspired by a surprising array of sources.