Paying the Pied Piper of Passivity

The Pied Piper of Hamlin

“In the year of 1284, on the day of Saints John and Paul on June 26, by a piper, clothed in many kinds of colours, 130 children born in Hamelin were seduced, and lost at the place of execution near the koppen.”


We are all familiar with the tale of the brightly-clothed pied piper whose lovely tune was so enchanting as to lure a town’s entire population of children to their premature demise. Few may realize the legend was borne of true events. The Lower Saxony hamlet was battling a rat infestation and the pied piper originally labored to rid the scourge in exchange for payment. Rat-free, the townspeople reneged and paid dearly with their children’s lives, or so the story goes.

Listen to investing legend John Bogle and you too might be lulled. Not by music, but by a message that could have you believing that active investing should also have long ago met its own demise. The man is on top of his game with Vanguard, the firm he founded on September 24, 1974, raking in a record $236 billion last year. Total assets under management? A cool $3.1 trillion. (OK, you might should round down considering how this year has started.)

Nevertheless, Bogle makes beautifully salient points about passive investing. Active managers are too richly rewarded. Or in Bogle’s words from a Bloomberg interview last April, active mutual funds are “fat, dumb and happy,” soaking would-be retirees with excessive fees.

In many cases that assessment suits, especially when “closet indexing” is involved. Think handsomely rewarded “active” managers circa 2000 buying into the dotcom revolution’s poster children of profitless phantasmal prosperity. Or jump to present day and picture managers who veered blindly from concentrated to the core in Apple to a deep dive into the FANG stocks that we can all name.

What should be most important to investors is that index investing has proven its merit, outperforming its actively-managed peers. Morningstar tracked 562 actively managed large-cap growth stock mutual funds and 25 passively managed funds in the same asset class. In the decade through yearend 2014, passive outperformed by a significant margin, with average returns of 9.27 percent compared to managed funds’ 8.05 percent.

Bogle’s prediction: “In 25 to 30 years, they’ll be gone. That seems like an extreme statement, but I think it isn’t without possibility.”

Spend nearly a decade as an outsider inside the Federal Reserve and you realize the perilous nature of Bogle’s arguably logical conclusion. Data, one comes to understand, is akin to an artist’s canvas, clay or marble; it can be painted, molded and sculpted, conforming to the artist’s strokes. Framing timeframes is by far the most convenient method to help the data assume the shape of your intended outcome.

Don’t like the way inflation trends behave going back to the 1800s when deflation was a much more common occurrence? Slice right through history and begin in a postwar world. And voila. The results pan out just as you’d hypothesized. It bears mentioning that this line of thought has infected the collective mindset of the current generation of economists at the Fed and gone a long way towards perfecting models that justify the stifling of the business cycle.

Be mindful, in other words, that Morningstar examined ten years in which easy monetary policy ruled the financial markets’ roost. It should be no wonder that stock picking can be placed right up there beside bungee jumping with a broken cord.

In the event the little hairs on the back of your neck are standing up, that’s your subconscious asking a pertinent question: Are central bankers omnipotent? Do they have the ability to keep Mother Nature at bay indefinitely?

If you believe that to be the case, then double down in index investing. But if you’re a wee bit skeptical, consider the following less discussed index fund investing attributes care of Schroders’ Alistair Jones.

Equity index funds weight their stocks by their market capitalization. That means the go-go stocks with the most inflated prices drive the train. In a report, Jones warned “The problem is that market cap weighted indices can force investors to buy stocks with expensive valuations and sell cheap ones.” He goes on, “In other words, buy high and sell low.”

For those keeping track, the broad index is off by one percent since December 2014 but has suffered a decline of five percent if you net out the top 10. That tony top cohort is up by 17 percent over the same time frame. But the parallel with 1999 should stand as warning enough to passive investors comforted by how well their portfolios have performed. What spikes upwards will crash just as violently when the air rushes out of these bubbling stocks.

Jones’ second reservation has to do with this concept we used to be familiar with called ‘price discovery.’ Value, we learned in portfolio management 101, is what you buy at a fair price. The implication is that good companies can be bad values. “Passive managers,” Jones explains, “are not able to distinguish between good and bad, wheat or chaff. They are forced to invest in all the stocks in an index, irrespective of any views about their value or quality.”

Jones’ last concern drives at why investors have piled into passive funds care of the Fed’s enticing investors into risky assets with their own special strain to which worryingly few are impervious. Rather than disappear and never be seen by their parents again, as was the case with the town’s children and the 11th century piper, investors must reckon with the systemic risk that permeates the markets when boom turn to bust.

The bullish cabal continues to insist that if you exclude energy from your calculus, all is hunky dory in the markets. The flaw in such naïve guidance is that excluding energy extends to excluding the commodities supercycle, the emerging markets renaissance it induced and the ‘miracle’ of China’s emergence onto the global economic stage that ignited the engine to begin with.

Hence the ultimately systemic outcome of lax monetary policy and the animal spirits it emboldens when seeking out the philosopher’s stone.

Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure – there wouldn’t have been the wholesale herding into passive funds these last few years.

Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser.

Last Friday, Mario Draghi sang acapella to the roaring applause of financial markets, which rallied to close in positive territory for the first time in a month.

It’s likely that the Wall Street Journal’s Greg Ip answered the mother of all questions posed by passive investors. Their query: Why bother with the nitty gritty of identifying value in individual securities in a world in which macro is all that matters?

Ip’s answer: “Just as the Fed doesn’t determine the breadth of the boom, it can’t dictate the scale of the bust.”

The conventional wisdom is that a rising interest rate environment will lay the groundwork for active managers to finally outshine their passive brethren. A recession ensues outing the passive managers as sheep in wolves’ clothing – all good on the upside, brutal on the downside. But what if recession emerges without being triggered by a textbook tightening cycle?

The world as we know it has become dangerously interconnected. We read about the trillions of dollars of dollar-denominated emerging markets bonds that have been issued in recent years to say nothing of the explosion in supposedly safe developed-market debt and pretend that rationality has played a part.

We delude ourselves into believing that events halfway around the world can be contained. Recall the last time we bought into the notion of events being contained and consider yourself forewarned.

In the fabled fable of the Pied Piper, there was only one lucky child who was spared. The lucky child depends on the version of the story being told. In one version it was a lame child who could not keep up with the mass exodus, another version spares a deaf child, perfectly immune to the fatal melody, and still another version saves a blind child who could not make his way.

Are there modern day parallels to the survivors, ardent disciples of Graham & Dodd and idealistic short sellers standing sentry against corporate malfeasance’s entry? We can only hope.

The Fed Awakens

Fed hike

What if Mario Draghi really did whip out a bazooka?

On December 3rd, the stock market pitched a fit reacting to what it perceived to be insufficient stimulus on the part of the European Central Bank (ECB). The market had wanted “Super Mario,” as investors have lovingly nick-named the ECB president, to take two measures.

The first would have expanded the quantitative easing (QE) program, increasing the amount of securities the ECB is committed to purchase. The second would have cut already negative deposit rates by -0.15%; Draghi only delivered -0.1% (negative rates penalize banks for holding excess cash at the EBC when they could lend it out to spur economic growth.)

Borrowing a page out of New York Federal Reserve President Bill Dudley’s battle plan, Draghi did manage to push through a much more forward-looking program – reinvestment of any proceeds that result from securities maturing on its balance sheet. Bratty fast-money, instant gratification investors dismissed the move.

Draghi, though, never looked more the cat that ate the canary than he did the next day in New York. He vociferously reiterated his commitment to do whatever it takes to get inflation to the ECB target, as long as that might take. If QE wars need be fought long into the future, reinvestment will strategically position Draghi on the central banking battlefield.

Back at home, many market watchers are scratching their heads as to why the Fed would be raising rates at this juncture. Financial conditions have tightened, not eased, since the Fed pushed the hold button at its September meeting. And yet, the markets and economist community remain unanimous that the Fed will pull the trigger.

What if it really is all about reinvestment and not one teensy quarter-point rate hike? Over the next three years, some $1.1 trillion in Treasurys could roll off the Fed’s balance sheet if reinvestments were to cease. Tack on the potential for mortgage backed securities (MBS) to prepay and/or mature and you’re contemplating a figure that approaches $2 trillion.

Make no mistake, shrinkage of the Fed’s balance sheet to half its current size is much more feared by market participants than a slight tick-up in interest rates. Taking the step to not reinvest would increase the supply of Treasurys and MBS available to investors and reduce the Fed’s support of the economy. The higher the supply on the market, the lower the price and hence, higher the yield, which moves opposite price.

“It seems to me you’d like to have a little room before you start ending the reinvestment… (which) is a tightening of monetary policy.” So said Dudley on June 5th to a group of reporters. He went on to define how big the ‘room’ needs to be a “reasonable level.”

“By how far that is – you know, if it’s 1 percent or 1.5 percent – I haven’t reached any definitive conclusion.”

At the risk of allowing the appearance of decision-making to occur in unilateral fashion on Liberty Street, Fed Chair Janet Yellen made clear to reporters that the entire Federal Open Market Committee (FOMC) was tasked with determining the future size of the balance sheet.

In a June 17 Q&A session that followed the FOMC meeting, Yellen assured the public that, “President Dudley was expressing his own personal point of view, but this is a matter that the committee has not yet decided and I cannot provide any further detail.”

But what if there’s more than one way to skin the reinvestment cat?

The interest rate markets that determine the cost at which banks lend to one another is notoriously illiquid at the end of calendar quarters and years. The Fed knows this. That makes the insistence on raising interest rates this month all the more intriguing given the pressures emanating from the corporate bond market.

As watching-paint-dry boring as the mechanics surrounding the actual rate hike are, a rudimentary understanding is crucial to grasping the tumultuous nature of the deliberations among FOMC voting members. (That was a preamble to implore the reading of the next few paragraphs.)

The overnight fed funds rate market, which the Fed employed to embark on its last rate-hiking cycle, is a shadow of its former self in terms of trading volumes. We’re talking about $50 billion a day compared to today’s theoretical $2 trillion in institutional cash dehydrating on bank balance sheets parched for safe positive yields.

It’s a complete unknown what portion of this $2 trillion would rush off bank balance sheets into money market funds. That said, it’s a slam-dunk assumption that the demand for higher yields is ubiquitous among those making south of nothing on their cash.

Planning for a complete unknown dictates that the Fed be flexible in trying to minimize overnight rate market upheaval. Funny thing – policymakers have a tool that can maximize a smooth transition called the reverse repurchase ‘repo’ (RRP) facility.

In the post-zero interest rate world, which celebrates its seven-year anniversary the day the Fed is expected to raise rates, repo markets determine overnight rates. Banks and other financial institutions swap collateral in the form of U.S. Treasurys, MBS and corporate debt to other investors for cash. In that these are overnight trades to facilitate the shortest-term funding needs, the bank buys back the securities the next day.

A bank in the above example that’s selling securities overnight, with the understanding they’ll buy them back the next day, is entering into the repurchase agreement. The party on the other side of the transaction, which buys the securities overnight agreeing to sell it back the next day, has entered into a reverse repurchase agreement.

Mitigating any disruptions in this market is key to a successful initial rise in interest rates. That’s saying something when the size of the collateral market has already shrunk from $10 trillion in 2007 to $6 trillion today. A rate hike, in its simplest form, involves reducing the liquidity in the system from this $6 trillion starting point. It follows that the Fed can use its RRP to absorb liquidity using money market funds as the conduit.

The problem is the RRP is currently capped at $300 billion per day, a fraction of the potential demand for the discernible yield money market funds will presumably be able to offer in a positive rate environment.

Of course, the Fed could satisfy the need to provide the market with collateral by selling Treasurys, but again this shrinks the balance sheet.

What of the elegant solution cleverly proposed by Dudley, you ask? The answer: Temporarily lift the cap off the RRP to act in the markets’ best interest. In the blink of an eye, the money market fund industry will be completely dependent upon the RRP as a one-stop shop for overnight collateral. In a world bereft of collateral sourcing to begin with, how could such a dependency imply anything “temporary”?

The short answer is it won’t. The long-term devilishly detailed answer: Yes, the Fed uncapping the RRP would succeed in tightening financial conditions by absorbing monies from the money market funds that will be flooded with deposits. But this maneuver will not release the collateral from the Fed’s balance sheet. The size of the mammoth balance sheet would thus be largely held intact.

Perhaps this is why we’ve been hearing dissentious grumblings from unusual suspects such as Fed Board governors Lael Brainard and Daniel Tarullo. Monetary policy is effectively being determined mechanistically at an illiquid time of the year notorious for mechanical dysfunction. Policymaking by proxy has to bristle even the loyalist of consensus builders.

Recall that there have been only four dissents on the part of Fed governors over the past 20 years (Federal Reserve district president dissents are relatively-speaking a common occurrence). If dissent weren’t a clear and present danger, why would Yellen warn Congress she’s prepared to push forward with a rate hike in spite of potential dissents? The chair could easily have been referring to mutinous governors.

Since the creation of the RRP, policymakers have gone to great pains to reassure the public they have the political will to shrink the facility when the time comes. That would be quite the acrobatic act if the money market fund industry becomes reliant on the RRP for daily functionality.

Conveniently, with markets pricing in all of two additional rate hikes in 2016, we’ll never get to Dudley’s 1 to 1.5-percent overnight rate that justifies shrinking the balance sheet.

Will policymakers have the luxury of time to raise interest rates enough to combat the next recession? Looking 12 months out, it’s much more likely that the business cycle will have turned. As the Wall Street Journal has pointed out, at 78 months, the current expansion is longer than 29 of the 33 dating back to 1854.

There’s no doubt the Fed’s first rate hike in nearly a decade is an awakening. The open-ended question is the true motivating factor. Perhaps investors should cue off Draghi’s recent success in securing ECB balance sheet reinvestment and connect the dots from there.