Wednesday, October 15th, 2014

The context for investment decision making is constantly evolving, but the evidence of history is hard to escape.  It exerts a pull on us even when we acknowledge that it might not be representative of the future.

As I have written before, modern finance is a young discipline and the investment ecosystem of today doesn’t look anything like that of 1983, when I entered the business.  That’s not very long ago and, oh, by the way, interest rates have been dropping the whole time.  Not exactly representative of the range of possibilities.

In any case, I spend a lot of time thinking about how organizations and individual decision makers develop the assumptions on which they invest.  The historical record creates a powerful conceptual frame.  For asset owners and their advisors, there are broad assumptions that form the grid on which actions are mapped — returns, volatilities, and correlations especially.

But what if the patterns of the past don’t really fit with the world of today?  Consider these actors in the market drama:

Passive investors ~ The percentage of assets under management in passive strategies continues to march upward.  A recent article by Charles Ellis in the Financial Analyst Journalthe research puzzle | This is my review of the piece. and other chronicles of the shortcomings of active management will likely further support that trend.  But, with the exception of some rebalancing activity, passive investors take what the market gives them.  As Ellis acknowledged in an interview,Pensions & Investments | This is from an article titled, “Move to passive likely to build still more steam.” that means passive investors passively accept the “longitudinal mispricings” delivered by the market.

Machines ~ While there are quantitative strategies of all kinds, many are driven by what’s worked and what’s working.  The absolute price levels of the market or of a security are of little concern; it is their movements that matter.  And, yes, the machines might even trigger actions themselves with some “momentum ignition” if that has proven to be successful in the past.

Momentum players ~ Wherever the spark of momentum comes from, there are large numbers of momentum traders/investors in the market.  As confirmed by academic analyses and supported by sociological observations, price momentum is a powerful force and it drives behavior by lay and professional players alike.  Some forthrightly state momentum as their strategy, while others practice it under cover of a more marketable philosophy.

Relative performance investors ~ The gargantuan investment industry cannot be painted with one brush, but, for the most part, traditional asset managers make decisions on the basis of relative performance, since that’s how they are judged.  The weapon of cash has been taken out of their hands;CFA Institute | Here’s a posting I wrote for CFA Institute on the use (or non-use) of cash by investment managers. their goal is to beat their benchmark and their peer group (the members of whom are also aiming for relative performance).

C-suite traders ~ Aggressively pro-cyclical in their approach, corporations tend to buy back lots of stock when prices are high and confidence is high, and not so much when those things are low.

When taken together, these constituencies dominate the markets, and they aren’t price-setters driven by inherent value.  That’s fine; I’m not saying that their strategies are wrong in any sense, just that they feed off of each other in ways that may not be captured in the historical record.  (And I’m leaving out the Fed, which went from having an inferred “put” in place to clearly stating that it was trying to move asset prices higher.)

It might just be recency bias on my part — after all, the last twenty years are a study in big moves up and big moves down — but it seems to me that we have engineered a machine that will deliver greater peaks and valleys than what history shows and what we expect.  If that’s correct, there are serious implications for asset owners and the models on which they rely.

These major players tend to amplify trends rather than mute them.  When the party is young and the music is good, turning the amps up to eleven seems right.  At some point it just becomes loud noise and everyone wants to leave.