The mania for average returns has been suppressing short term losses, or corrections
A sound banker, alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.
— John Maynard Keynes
We have created a bubble in average. Waiters and childhood friends are no longer telling us about what miracle gold, oil, or tech stocks they bought at the right time. They are exchanging stories about low management fees on their index-tracking exchange traded funds.
This sounds like the warning bell at the top of a mania. Only now it is a mania in low transaction costs, average returns, and on-demand liquidity.
Most professional portfolio managers sneer at the “technical analysis” momentum traders, who buy if price charts point up and sell when the charts point down. These traders are seen as socially awkward eccentrics, picking magical price support and resistant lines up on home office trading screens.
True, the technical traders do not go to the same high level conferences as serious professional investors. Without really noticing it, though, much, if not most, of the investment establishment has turned into the class they most despise, which is to say back-office ’bot creators.
Index-based investment management, more sophisticated algorithmic trading, and even slow and steady buy-on-the-dips retail investing have all been suppressing short term losses, or corrections.
Short term asset price declines have been reversed by the wall of money coming out of active investment managers and into the accounts of low-cost index products. But this comes at the expense of making the eventual decline in a broad range of asset values not just painful, but catastrophic.
There is no greedy banker in a corner office on Broad Street who created this constellation of algorithmic death stars. Unfortunately for the political class, Wall Street listened to the denunciations of the risky strategies that led to the 2008 crash. So it concentrated on marketing “low-risk” investment strategies that promise all the liquidity that Grandma would ever need. In the event of another market crash, it will be harder to find convincing villains.
There was an interesting debate set up by Jim Grant of the Interest Rate Observer, a journal focused on financial markets, at his spring conference in New York last week. John Bogle, the founder of Vanguard, the fund house known for its low-cost ETFs, took the side of index investing.
On the other side, Steven Bregman of Horizon Kinetics, the New York-based investment advisory firm, made a serious case for stockpicking active management, including its social value of ensuring accurate price discovery.
Now, though, the ultra-low cost passive investing Mr Bogle pioneered is a few trillion dollars ahead. In the post-crisis world, his fundamental thesis that active management’s transaction costs eventually overcome any apparent performance edge has been reinforced by post-crisis monetary policy and slow growth.
As interest rates and returns are repressed, every basis point of extra transaction and portfolio management cost looms larger to the investor. And since every market dip is cushioned by central bank safety nets, the rise of index values has been looking ever more inexorable.
All those waiters and childhood friends will tell you they have liquidity, as in the right to cash in, whenever they want, at a low cost. The index fund managers get that liquidity by buying more of the most liquid securities, which then rise in price even faster. However, on the way down, this virtuous cycle tends to reverse.
And it is not clear how a society with population growth below 1 per cent, and productivity growth below 2 per cent, provides long term returns of 4 per cent to an ever larger group of retirees. Especially if it pulls back on international capital flows.
Serious-money portfolio managers will argue, correctly, that commodities and stock option buyers among the investing public usually lose their premium money. And yes, most amateur technical analysis investors eventually give up on charting their way to a fortune.
But professional portfolio managers have no day job to go back to. So they could be worse off than momentum traders working from home.