A Duration-Bubble Or A Low-Volatility Bubble?
September 02, 2019
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I'm a fan of Antipodes Partners, in addition to ever detect their commentaries insightful. In the company's latest investor update (see below), founder in addition to CIO Jacob Mitchell provides a number of useful insights, but ane of the arguments he makes is that investors receive got been 'chasing duration' to an unprecedented extent inward the post-GFC era. Slide seven is quite revealing. Mitchell's total presentation runs from 5.50 to 22.00 (all of which I recommend), amongst the relevant department for this article on duration running from 10.05-14.45.
It's an interesting argument. However, I'm non convinced Jacob's characterization of today's bifurcated markets every bit beingness primarily a portion of investors chasing 'duration' is alone accurate. I recollect what has genuinely been happening is that inward the post GFC era, investors receive got been chasing property classes/factors/styles which receive got (or are perceived to have) low volatility/drawdown risk, in addition to concomitantly eschewing those amongst higher volatility/drawdown risk. It has piddling to do amongst duration per se, inward my view. After all, per 11.15-14.45/slide 8 of Mitchell's presentation, the duration of the cash flows associated amongst ownership of European depository fiscal establishment equities is longer than many of the low-yielding debt instruments used every bit a comparing (in an otherwise rattling proficient argument).
The beginning of this to a greater extent than than decade-long megatrend lies inward the wreckage of the Global Financial Crisis (GFC), which was a formative lawsuit for an entire generation of investors in addition to property allocators. It was a 'return shock' of tremendous proportions, where pretty much anything exposed to equities was downwards 50% or to a greater extent than on a marked-to-market solid set down inward every bit piddling every bit 6-12 months. Furthermore, dissimilar the dot.com bust, at that spot was nowhere to hide. In 2000-02, lots of old-world value sectors/stocks surged every bit tech stumbled, in addition to emerging marketplace seat equities also boomed during 2000-2007. The GFC was different - 'correlations went to 1', every bit they say, in addition to equities everywhere tanked. Many value guys were also heavily exposed to financials in addition to suffered badly. This GFC sense has cast a long shadow, in addition to has had important implications on how markets receive got functioned ever since.
It has ever been the instance that meaningful portions of the investment Blue Planet cannot afford to sustain large mark-to-market (M2M) drawdowns, but the GFC in addition to a number of other developments I hash out below receive got meaningfully amplified this behaviour. Insurers, for instance, are required to grade equity investments to market, in addition to large drawdowns tin hence force per unit of measurement area regulatory uppercase in addition to imperil rating-agency production ratings, which tin inward plough impair their powerfulness to write novel line of piece of work organisation (or fifty-fifty hold every bit a going concern).
As a result, insurers rest focused on high-grade fixed income securities, almost irrespective of yield in addition to key risk/reward, due to the relatively depression associated M2M risks, in addition to the extent of the GFC drawdown has caused them to allocate fifty-fifty less to equities, in addition to peculiarly high-risk equity exposures. However, every bit sufficient yield has instruct increasingly had to come upward yesteryear inward the QE-addled post-GFC period, they receive got sought to supplement their fixed income portfolios amongst increasing allocations to 'alternatives'. These initially included hedge funds, but inward to a greater extent than recent times, the preference has migrated towards private equity in addition to venture capital.
Pension funds receive got behaved inward a similar style post-GFC - albeit non to the same extent, in addition to they retain much larger equity exposures. In theory, pension funds ought to receive got the best powerfulness of all marketplace seat participants to withstand brusque term M2M volatility in addition to invest inward long-duration assets such every bit stocks, to correspond off against their long-duration liabilities. However, the duration of pension funds' liabilities unremarkably exceeds the duration of the occupation tenures of most of the people running them, in addition to no ane wants to preside over a important portion of the assets backing their pension liabilities declining yesteryear 50% on their watch. Because many organisations saw exactly that come about to their equities exposure inward the GFC, a major aversion to equities inward general, in addition to to a greater extent than volatile/economically-sensitive sectors/regions/style factors inward particular, has developed.
In the post GFC period, hedge funds were initially seen every bit an attractive alternative property class, every bit they promised to furnish equities exposure amongst downside volatility protection - peculiarly because several hedge funds succeeded inward non only protecting uppercase during the GFC, but also profiting mightily from 'the large short'. However, due exactly to many of these funds' focus beingness on hedging downside volatility/drawdown risk, they receive got also relinquished most of their returns over the yesteryear decade every bit well. GMO's query has shown that the long term render on writing cash-covered set options on marketplace seat indices has been almost the same every bit the market's total return. The implication of this is that yous receive got historically needed to surrender 100% of your expected render beingness long equity indices inward guild to hedge the downside yesteryear buying index set options. With equity indices - peculiarly inward the USA - having risen incessantly over the yesteryear decade, hedge funds receive got accordingly delivered pathetic returns for this reason, exacerbated yesteryear express alpha generation in addition to high fees.
The GFC also had the upshot of causing many active managers to displace from under-estimating the likelihood of crises earlier the GFC, to dramatically over-estimating the likelihood inward the GFC's wake - peculiarly because the GFC set inward motion diverse regulatory/policy/behavioural responses designed specifically to foreclose a recurrence (including much tighter banking regulation, in addition to much to a greater extent than conservative lending). The GFC catapulted to fame in addition to fortune many hedge fund managers amongst relatively brusque runway records that had successfully bet on disaster. Funds flooded into these managers. But their pathetic subsequent records - every bit they receive got hold to bet on myriad other macro blow-ups which receive got non occurred - betoken that they were generally just lucky pre GFC, rather than prescient. Many copy-cat macro-oriented hedge funds also emerged that tried to hold upward the side yesteryear side Paulson or Burry, who bet heavily on diverse crises occurring which did not. This 'generals fighting the final war' approach cost their investors a lot of money, in addition to discredited hedge funds. Investors fled.
With hedge funds disappointing, in addition to amongst yields on fixed income instruments - the ultimate property course of educational activity providing a refuge from 'volatility risk' - declining to a mere pittance (if that), coin has instead rushed into private equity in addition to venture capital. This is intriguing, because private equity is essentially piddling to a greater extent than than leveraged equities exposure - albeit amongst greater powerfulness to influence administration demeanour in addition to uppercase resources allotment - spell venture uppercase is also involved inward the riskiest equity bets of all - funding start-ups, most of whom are destined to drib dead to zero. It appears to hold upward a foreign house for investors to seek out low-risk returns.
However, the adventure investors are seeking to avoid is non fundamental/valuation risk, but mark-to-market drawdown adventure - peculiarly over shorter fourth dimension horizons (by the fourth dimension things blow up, the administration teams inward accuse of making making property resources allotment decisions may receive got already retired amongst their bonuses safely banked). The wages PE/VC 'asset classes' receive got over traditional equities is that they don't demand to grade their positions to marketplace seat every day/month/quarter, in addition to are hence able to industry the illusion of returns without volatility - something that has considerable practical value for many of their volatility-phobic investors. Tech VC also has the farther wages of beingness able to grade the carrying value of their investments to the latest uppercase raising valuation - fifty-fifty if they are the only fund participating inward such a raising.
However, the impact of this volatility-phobia has non just been a reallocation of funds from equities into 'alternatives', but also into equities exposures that hope returns amongst relatively express volatility/risk. This has included a rotation into 'bond proxy' equities such every bit consumer staples, utilities, etc; dependable structural increase stories such every bit large cap tech; in addition to condom jurisdictions without Fx adventure such every bit the US; spell avoiding sectors plain of written report to macro sensitivity or other uncertainties, in addition to jurisdiction amongst greater political, economic, or Fx risk.
This aversion to volatility/risk has also oftentimes been effectuated through the utilization of ETFs coupled amongst 'smart-beta', 'risk-parity' in addition to 'factor-based' investment strategies, spell investors receive got also favoured active managers delivering performance amongst express drawdowns. This volatility-phobic tendency has been accentuated yesteryear robo-advisers in addition to other algorithmic property resources allotment strategies, which all seek to optimise the same equation - relatively high returns amongst relatively depression 'risk', amongst adventure defined every bit volatility/drawdown adventure (i.e. the classic 'sharp' ratio). And the algobots assess these characteristics using historical information series.
What this has meant inward exercise is that equity marketplace seat 'factors' that receive got been delivering proficient returns amongst relatively express volatility/drawdowns receive got been attracting to a greater extent than in addition to to a greater extent than money. These inflows receive got so inward plough contributed to farther strong returns amongst comparatively express drawdowns (as when markets swoon, incessant inflows moderate the size of the drawdown vs. factors experiencing outflows, which autumn fifty-fifty farther inward marketplace seat sell-offs). This flywheel upshot has accentuated in addition to prolonging pre-existing marketplace seat momentum (kickstarted yesteryear a flying to quality/low-volatility inward the risk-averse climate of the GFC's aftermath), in addition to tricked algobots into believing for certain 'factors' such every bit 'growth' in addition to 'quality' receive got improve enduring risk/reward characteristics than other factors such every bit 'value', when inward reality, it only reflects a bubble inward flows.
An prime number illustration of the folly is 'low volatility' ETFs - ETFs that invest inward 'low volatility' stocks, which receive got grown significantly inward popularity. Imagine if a important fraction of the stocks comprising low-vol ETFs came to hold upward held yesteryear 'low-volatility' ETFs. What would come about if the stocks all of a precipitous spiked downwards in addition to became highly volatile? Two things: (1) the ETF would receive got to sell them, because the stocks are no longer 'low volatility'; in addition to (2) the investors inward the low-volatility ETF would sense highly-volatile outcomes. They would say, 'this is non what nosotros signed upward for', in addition to delineate their coin out. In combination, this could drive a crash inward 'low volatility' stocks. It would hold upward difficult to pattern an ETF to a greater extent than foolish in addition to prone to a total blow up. But until that inflection dot is reached, so long every bit to a greater extent than coin keeps flowing into depression volatility ETFs, the stocks volition perform good in addition to won't drib dead down, every bit the inflows hold to back upward their 'low volatility' performance.
Incidentally, this is ane of the key problems/dangers amongst 'big data' inward the investment world. Big information inward markets is different to large information in, say, baseball game (I highly recommend the volume 'Big Data Baseball', which is Moneyball on steroids). Big information inward baseball game makes it possible to to a greater extent than in addition to to a greater extent than accurately appraise the truthful value of private players (which every bit discussed inward the book, has hitherto sometimes been hidden), but although it may touching instrumentalist choice in addition to on-field strategies, it does non ultimately touching those underlying contributions/attributes. Furthermore, virtually 100% of what happens during a baseball game play has happened earlier - oftentimes thousands in addition to thousands of times. Algos are keen at analysing this kind of voluminous information in addition to sifting out hidden relationships/patterns invisible to mere mortals. In these sorts of contexts, large information tin receive got a huge impact, in addition to brand the marketplace seat inward baseball game players (and on-field strategies) far to a greater extent than 'efficient'.
Financial markets don't piece of work that way, because the render in addition to volatility information sets are backwards looking, in addition to the algos cannot anticipate discontinuities, or something happening that has non happened earlier inward the datasets. History, in addition to our information collection to date, has simply been also brusque to line of piece of work organisation human relationship for the myriad of all possible outcomes. If at that spot had already been 500,000 housing bubbles in addition to busts, perchance the information sets could predict futurity bubbles in addition to all the relevant factors, but at that spot haven't been. There had never been a national housing bust inward the USA earlier the GFC, so it wasn't inward the data, in addition to was hence invisible to the bots. If yous asked the algos inward 2005, they would receive got told yous a nationwide crash was a 10-sigma lawsuit almost impossible to occur. But they were wrong, every bit the yesteryear information sets reflected ex post outcomes, non ex ante probabilities inward a novel situation. It's similar setting baseball game 'big data' bots to piece of work when they only receive got 3 pitches worth of data. If all 3 pitches receive got been strikes, so the bots volition recollect a strike happens every ball.
Furthermore, the rattling behaviours these bots drive tin genuinely alter the futurity probabilities inward a reflexive in addition to (to the bots) unpredictable way. The rattling belief that a nationwide housing crash was a 10-sigma lawsuit was a key contributor to the creation of the housing bust (as it caused ratings on MBSs to hold upward far also high, enabling an excessive flow of credit into the sector). It was an active contributor, non just a failure of passive prediction. In much the same way, the algobot search for high returns amongst depression volatility/risk is creating a province of affairs where the stocks amongst the best best returns potential in addition to amongst the lowest adventure genuinely reside inward the exact same stocks the bot algos eschew, in addition to vice versa.
It hasn't just been algobots driving a bubble inward depression volatility, however. The demeanour of both terminate investors in addition to active equity managers has also reflected these megatrends. Aging demographics agency that at that spot is a large cohort of investors approaching retirement historic catamenia inward evolution markets, in addition to the GFC was a major stupor to the retirement accounts of many of this cohort. They tin ill-afford to run into 50% of their retirement savings wiped out ane time to a greater extent than on the eventide of their retirement. This large course of educational activity of uppercase is hence right away rattling sensitive to volatility in addition to drawdown risk, in addition to this adventure aversion is impacting non just their property allocation, but also their choice of property managers in addition to the types of equity exposures they are prepared to run: they receive got shifted funds into managers delivering steady gains amongst depression volatility, in addition to away from those amongst variable returns, and/or receive got allocated funds to ETFs or 'smart beta' ETFs amongst similar dynamics. But it is this rattling behaviour, writ large, that has been driving the high returns in addition to depression volatility inward the fist place.
End-investor demeanour has also affected the demeanour of active fund managers, because a long-standing number for equity managers has ever been that they are only able to hold upward every bit patient in addition to volatility-tolerant every bit their terminate investors. If their investor base of operations cannot 'wear' downside volatility, these organisations volition actively avoid property classes, regions in addition to sectors that expose their funds to meaningful brusque term drawdown risk. They volition do this because fifty-fifty if buying inexpensive but volatile stocks volition Pb to a improve long term outcome for their investors, it represents an unacceptably high line of piece of work organisation risk. If they endure massive redemptions, they may drib dead bust or (from the perspective of the private PM) hold upward set off long earlier the dot of reversal arrives.
Exacerbating these trends further, the Blue Planet of institutional funds administration has been consolidating over the yesteryear decade, every bit to a greater extent than in addition to to a greater extent than coin has flowed into passive strategies, in addition to fee compression has emerged. Many smaller shops receive got folded, in addition to many large managers receive got been merging inward guild to cut back costs (and hence fees). However, this has resulted inward larger in addition to larger funds, in addition to to a greater extent than in addition to to a greater extent than coin flooding into the same large-cap structural increase or quality/low-volatility names, pushing upward multiples further.
All of these forces inward combination receive got resulted inward crowding into the same, right away highly-expensive segments of the market, in addition to the wholesale abandonment of other sectors, in addition to inward my submission is the existent argue nosotros run into the broad disparity inward multiples in addition to render profiles Antipodes has ably referenced. Its non that investors aren't prepared to aspect for structural increase inward 'less obvious places' - it's that they aren't prepared to/can't afford to atmospheric condition brusque term drawdowns.
Sure, dividend yields on European banks inward audio fiscal positions are right away 7% (on 50% dividend payouts), vs. unopen to null for junior debt instruments owed yesteryear those same institutions. But if yous purchase the stock, yous mightiness hold upward downwards 5-10% inward a hateful solar daytime on a marked-to-market solid set down (as occurred inward August), whereas that volition non come about for a held-to-maturity debt musical instrument (debt instruments tin hold upward accounted for every bit 'held to maturity' yesteryear fiscal institutions, in addition to hence non marked to marketplace seat (unless 'impaired'), but at that spot is no such matter every bit 'held to maturity' for equities). It's non almost duration - it's almost mark-to-market volatility risk. GE in addition to Siemens offering structural increase inward less obvious places at a much lower price? Sure, but yous mightiness hold upward downwards 5-10% inward a hateful solar daytime if people worry almost the outlook for global growth, or the size of GE's LTC insurance reserves.
This is how yous terminate upward inward a Blue Planet where many markets are expensive, in addition to nominal long bond yields are about zero, but yous tin soundless purchase some stocks on extraordinarily depression prices - oftentimes marketplace seat leading companies amongst long term increase potential amongst dividend yields of 10%, but which come about to hold upward cyclical or plain of written report to another cast of dubiety that is inducing part cost volatility. It makes no sense, until yous recognise that most investors simply can't atmospheric condition the volatility, in addition to algobots volition dump stocks exhibiting pathetic brusque term Sharp ratio optimisations inward a self-reinforcing manner. It's also how yous terminate upward inward a Blue Planet where the vast bulk of value investors amongst keen long term records are underperforming the indices - sometimes yesteryear a sizable margin.
The outcome is that at that spot are right away extraordinary opportunities emerging inward global markets for the volatility-tolerant long term investor. The Blue Planet has a vastly excessive abundance of low-volatility capital, but a growing in addition to acuate shortage of high-volatility capital. Like all opportunities inward markets, however, the magnitude of the chance is proportional to the challenges of successfully exploiting it at scale - it is inward this abide by that markets are both highly inefficient, and offer no complimentary tiffin (something the academics missed). The chance is large because it's difficult to attract a lot of coin at the instant to implement such a strategy - most of the funds doing so are currently suffering redemptions. If it were slowly exploit, the chance would disappear. That's how markets work.
Personally speaking, I receive got the proficient fortune of beingness a small-time director amongst a depression cost base of operations in addition to my ain permanent equity uppercase invested, in addition to only demand a handful of loyal, long term investors to brand a decent living. As far every bit I'm concerned, the electrical flow surroundings is a wonderful chance if you're fortunate plenty to hold upward inward a seat to exploit it.
LT3000
It's an interesting argument. However, I'm non convinced Jacob's characterization of today's bifurcated markets every bit beingness primarily a portion of investors chasing 'duration' is alone accurate. I recollect what has genuinely been happening is that inward the post GFC era, investors receive got been chasing property classes/factors/styles which receive got (or are perceived to have) low volatility/drawdown risk, in addition to concomitantly eschewing those amongst higher volatility/drawdown risk. It has piddling to do amongst duration per se, inward my view. After all, per 11.15-14.45/slide 8 of Mitchell's presentation, the duration of the cash flows associated amongst ownership of European depository fiscal establishment equities is longer than many of the low-yielding debt instruments used every bit a comparing (in an otherwise rattling proficient argument).
The beginning of this to a greater extent than than decade-long megatrend lies inward the wreckage of the Global Financial Crisis (GFC), which was a formative lawsuit for an entire generation of investors in addition to property allocators. It was a 'return shock' of tremendous proportions, where pretty much anything exposed to equities was downwards 50% or to a greater extent than on a marked-to-market solid set down inward every bit piddling every bit 6-12 months. Furthermore, dissimilar the dot.com bust, at that spot was nowhere to hide. In 2000-02, lots of old-world value sectors/stocks surged every bit tech stumbled, in addition to emerging marketplace seat equities also boomed during 2000-2007. The GFC was different - 'correlations went to 1', every bit they say, in addition to equities everywhere tanked. Many value guys were also heavily exposed to financials in addition to suffered badly. This GFC sense has cast a long shadow, in addition to has had important implications on how markets receive got functioned ever since.
It has ever been the instance that meaningful portions of the investment Blue Planet cannot afford to sustain large mark-to-market (M2M) drawdowns, but the GFC in addition to a number of other developments I hash out below receive got meaningfully amplified this behaviour. Insurers, for instance, are required to grade equity investments to market, in addition to large drawdowns tin hence force per unit of measurement area regulatory uppercase in addition to imperil rating-agency production ratings, which tin inward plough impair their powerfulness to write novel line of piece of work organisation (or fifty-fifty hold every bit a going concern).
As a result, insurers rest focused on high-grade fixed income securities, almost irrespective of yield in addition to key risk/reward, due to the relatively depression associated M2M risks, in addition to the extent of the GFC drawdown has caused them to allocate fifty-fifty less to equities, in addition to peculiarly high-risk equity exposures. However, every bit sufficient yield has instruct increasingly had to come upward yesteryear inward the QE-addled post-GFC period, they receive got sought to supplement their fixed income portfolios amongst increasing allocations to 'alternatives'. These initially included hedge funds, but inward to a greater extent than recent times, the preference has migrated towards private equity in addition to venture capital.
Pension funds receive got behaved inward a similar style post-GFC - albeit non to the same extent, in addition to they retain much larger equity exposures. In theory, pension funds ought to receive got the best powerfulness of all marketplace seat participants to withstand brusque term M2M volatility in addition to invest inward long-duration assets such every bit stocks, to correspond off against their long-duration liabilities. However, the duration of pension funds' liabilities unremarkably exceeds the duration of the occupation tenures of most of the people running them, in addition to no ane wants to preside over a important portion of the assets backing their pension liabilities declining yesteryear 50% on their watch. Because many organisations saw exactly that come about to their equities exposure inward the GFC, a major aversion to equities inward general, in addition to to a greater extent than volatile/economically-sensitive sectors/regions/style factors inward particular, has developed.
In the post GFC period, hedge funds were initially seen every bit an attractive alternative property class, every bit they promised to furnish equities exposure amongst downside volatility protection - peculiarly because several hedge funds succeeded inward non only protecting uppercase during the GFC, but also profiting mightily from 'the large short'. However, due exactly to many of these funds' focus beingness on hedging downside volatility/drawdown risk, they receive got also relinquished most of their returns over the yesteryear decade every bit well. GMO's query has shown that the long term render on writing cash-covered set options on marketplace seat indices has been almost the same every bit the market's total return. The implication of this is that yous receive got historically needed to surrender 100% of your expected render beingness long equity indices inward guild to hedge the downside yesteryear buying index set options. With equity indices - peculiarly inward the USA - having risen incessantly over the yesteryear decade, hedge funds receive got accordingly delivered pathetic returns for this reason, exacerbated yesteryear express alpha generation in addition to high fees.
The GFC also had the upshot of causing many active managers to displace from under-estimating the likelihood of crises earlier the GFC, to dramatically over-estimating the likelihood inward the GFC's wake - peculiarly because the GFC set inward motion diverse regulatory/policy/behavioural responses designed specifically to foreclose a recurrence (including much tighter banking regulation, in addition to much to a greater extent than conservative lending). The GFC catapulted to fame in addition to fortune many hedge fund managers amongst relatively brusque runway records that had successfully bet on disaster. Funds flooded into these managers. But their pathetic subsequent records - every bit they receive got hold to bet on myriad other macro blow-ups which receive got non occurred - betoken that they were generally just lucky pre GFC, rather than prescient. Many copy-cat macro-oriented hedge funds also emerged that tried to hold upward the side yesteryear side Paulson or Burry, who bet heavily on diverse crises occurring which did not. This 'generals fighting the final war' approach cost their investors a lot of money, in addition to discredited hedge funds. Investors fled.
With hedge funds disappointing, in addition to amongst yields on fixed income instruments - the ultimate property course of educational activity providing a refuge from 'volatility risk' - declining to a mere pittance (if that), coin has instead rushed into private equity in addition to venture capital. This is intriguing, because private equity is essentially piddling to a greater extent than than leveraged equities exposure - albeit amongst greater powerfulness to influence administration demeanour in addition to uppercase resources allotment - spell venture uppercase is also involved inward the riskiest equity bets of all - funding start-ups, most of whom are destined to drib dead to zero. It appears to hold upward a foreign house for investors to seek out low-risk returns.
However, the adventure investors are seeking to avoid is non fundamental/valuation risk, but mark-to-market drawdown adventure - peculiarly over shorter fourth dimension horizons (by the fourth dimension things blow up, the administration teams inward accuse of making making property resources allotment decisions may receive got already retired amongst their bonuses safely banked). The wages PE/VC 'asset classes' receive got over traditional equities is that they don't demand to grade their positions to marketplace seat every day/month/quarter, in addition to are hence able to industry the illusion of returns without volatility - something that has considerable practical value for many of their volatility-phobic investors. Tech VC also has the farther wages of beingness able to grade the carrying value of their investments to the latest uppercase raising valuation - fifty-fifty if they are the only fund participating inward such a raising.
However, the impact of this volatility-phobia has non just been a reallocation of funds from equities into 'alternatives', but also into equities exposures that hope returns amongst relatively express volatility/risk. This has included a rotation into 'bond proxy' equities such every bit consumer staples, utilities, etc; dependable structural increase stories such every bit large cap tech; in addition to condom jurisdictions without Fx adventure such every bit the US; spell avoiding sectors plain of written report to macro sensitivity or other uncertainties, in addition to jurisdiction amongst greater political, economic, or Fx risk.
This aversion to volatility/risk has also oftentimes been effectuated through the utilization of ETFs coupled amongst 'smart-beta', 'risk-parity' in addition to 'factor-based' investment strategies, spell investors receive got also favoured active managers delivering performance amongst express drawdowns. This volatility-phobic tendency has been accentuated yesteryear robo-advisers in addition to other algorithmic property resources allotment strategies, which all seek to optimise the same equation - relatively high returns amongst relatively depression 'risk', amongst adventure defined every bit volatility/drawdown adventure (i.e. the classic 'sharp' ratio). And the algobots assess these characteristics using historical information series.
What this has meant inward exercise is that equity marketplace seat 'factors' that receive got been delivering proficient returns amongst relatively express volatility/drawdowns receive got been attracting to a greater extent than in addition to to a greater extent than money. These inflows receive got so inward plough contributed to farther strong returns amongst comparatively express drawdowns (as when markets swoon, incessant inflows moderate the size of the drawdown vs. factors experiencing outflows, which autumn fifty-fifty farther inward marketplace seat sell-offs). This flywheel upshot has accentuated in addition to prolonging pre-existing marketplace seat momentum (kickstarted yesteryear a flying to quality/low-volatility inward the risk-averse climate of the GFC's aftermath), in addition to tricked algobots into believing for certain 'factors' such every bit 'growth' in addition to 'quality' receive got improve enduring risk/reward characteristics than other factors such every bit 'value', when inward reality, it only reflects a bubble inward flows.
An prime number illustration of the folly is 'low volatility' ETFs - ETFs that invest inward 'low volatility' stocks, which receive got grown significantly inward popularity. Imagine if a important fraction of the stocks comprising low-vol ETFs came to hold upward held yesteryear 'low-volatility' ETFs. What would come about if the stocks all of a precipitous spiked downwards in addition to became highly volatile? Two things: (1) the ETF would receive got to sell them, because the stocks are no longer 'low volatility'; in addition to (2) the investors inward the low-volatility ETF would sense highly-volatile outcomes. They would say, 'this is non what nosotros signed upward for', in addition to delineate their coin out. In combination, this could drive a crash inward 'low volatility' stocks. It would hold upward difficult to pattern an ETF to a greater extent than foolish in addition to prone to a total blow up. But until that inflection dot is reached, so long every bit to a greater extent than coin keeps flowing into depression volatility ETFs, the stocks volition perform good in addition to won't drib dead down, every bit the inflows hold to back upward their 'low volatility' performance.
Incidentally, this is ane of the key problems/dangers amongst 'big data' inward the investment world. Big information inward markets is different to large information in, say, baseball game (I highly recommend the volume 'Big Data Baseball', which is Moneyball on steroids). Big information inward baseball game makes it possible to to a greater extent than in addition to to a greater extent than accurately appraise the truthful value of private players (which every bit discussed inward the book, has hitherto sometimes been hidden), but although it may touching instrumentalist choice in addition to on-field strategies, it does non ultimately touching those underlying contributions/attributes. Furthermore, virtually 100% of what happens during a baseball game play has happened earlier - oftentimes thousands in addition to thousands of times. Algos are keen at analysing this kind of voluminous information in addition to sifting out hidden relationships/patterns invisible to mere mortals. In these sorts of contexts, large information tin receive got a huge impact, in addition to brand the marketplace seat inward baseball game players (and on-field strategies) far to a greater extent than 'efficient'.
Financial markets don't piece of work that way, because the render in addition to volatility information sets are backwards looking, in addition to the algos cannot anticipate discontinuities, or something happening that has non happened earlier inward the datasets. History, in addition to our information collection to date, has simply been also brusque to line of piece of work organisation human relationship for the myriad of all possible outcomes. If at that spot had already been 500,000 housing bubbles in addition to busts, perchance the information sets could predict futurity bubbles in addition to all the relevant factors, but at that spot haven't been. There had never been a national housing bust inward the USA earlier the GFC, so it wasn't inward the data, in addition to was hence invisible to the bots. If yous asked the algos inward 2005, they would receive got told yous a nationwide crash was a 10-sigma lawsuit almost impossible to occur. But they were wrong, every bit the yesteryear information sets reflected ex post outcomes, non ex ante probabilities inward a novel situation. It's similar setting baseball game 'big data' bots to piece of work when they only receive got 3 pitches worth of data. If all 3 pitches receive got been strikes, so the bots volition recollect a strike happens every ball.
Furthermore, the rattling behaviours these bots drive tin genuinely alter the futurity probabilities inward a reflexive in addition to (to the bots) unpredictable way. The rattling belief that a nationwide housing crash was a 10-sigma lawsuit was a key contributor to the creation of the housing bust (as it caused ratings on MBSs to hold upward far also high, enabling an excessive flow of credit into the sector). It was an active contributor, non just a failure of passive prediction. In much the same way, the algobot search for high returns amongst depression volatility/risk is creating a province of affairs where the stocks amongst the best best returns potential in addition to amongst the lowest adventure genuinely reside inward the exact same stocks the bot algos eschew, in addition to vice versa.
It hasn't just been algobots driving a bubble inward depression volatility, however. The demeanour of both terminate investors in addition to active equity managers has also reflected these megatrends. Aging demographics agency that at that spot is a large cohort of investors approaching retirement historic catamenia inward evolution markets, in addition to the GFC was a major stupor to the retirement accounts of many of this cohort. They tin ill-afford to run into 50% of their retirement savings wiped out ane time to a greater extent than on the eventide of their retirement. This large course of educational activity of uppercase is hence right away rattling sensitive to volatility in addition to drawdown risk, in addition to this adventure aversion is impacting non just their property allocation, but also their choice of property managers in addition to the types of equity exposures they are prepared to run: they receive got shifted funds into managers delivering steady gains amongst depression volatility, in addition to away from those amongst variable returns, and/or receive got allocated funds to ETFs or 'smart beta' ETFs amongst similar dynamics. But it is this rattling behaviour, writ large, that has been driving the high returns in addition to depression volatility inward the fist place.
End-investor demeanour has also affected the demeanour of active fund managers, because a long-standing number for equity managers has ever been that they are only able to hold upward every bit patient in addition to volatility-tolerant every bit their terminate investors. If their investor base of operations cannot 'wear' downside volatility, these organisations volition actively avoid property classes, regions in addition to sectors that expose their funds to meaningful brusque term drawdown risk. They volition do this because fifty-fifty if buying inexpensive but volatile stocks volition Pb to a improve long term outcome for their investors, it represents an unacceptably high line of piece of work organisation risk. If they endure massive redemptions, they may drib dead bust or (from the perspective of the private PM) hold upward set off long earlier the dot of reversal arrives.
Exacerbating these trends further, the Blue Planet of institutional funds administration has been consolidating over the yesteryear decade, every bit to a greater extent than in addition to to a greater extent than coin has flowed into passive strategies, in addition to fee compression has emerged. Many smaller shops receive got folded, in addition to many large managers receive got been merging inward guild to cut back costs (and hence fees). However, this has resulted inward larger in addition to larger funds, in addition to to a greater extent than in addition to to a greater extent than coin flooding into the same large-cap structural increase or quality/low-volatility names, pushing upward multiples further.
All of these forces inward combination receive got resulted inward crowding into the same, right away highly-expensive segments of the market, in addition to the wholesale abandonment of other sectors, in addition to inward my submission is the existent argue nosotros run into the broad disparity inward multiples in addition to render profiles Antipodes has ably referenced. Its non that investors aren't prepared to aspect for structural increase inward 'less obvious places' - it's that they aren't prepared to/can't afford to atmospheric condition brusque term drawdowns.
Sure, dividend yields on European banks inward audio fiscal positions are right away 7% (on 50% dividend payouts), vs. unopen to null for junior debt instruments owed yesteryear those same institutions. But if yous purchase the stock, yous mightiness hold upward downwards 5-10% inward a hateful solar daytime on a marked-to-market solid set down (as occurred inward August), whereas that volition non come about for a held-to-maturity debt musical instrument (debt instruments tin hold upward accounted for every bit 'held to maturity' yesteryear fiscal institutions, in addition to hence non marked to marketplace seat (unless 'impaired'), but at that spot is no such matter every bit 'held to maturity' for equities). It's non almost duration - it's almost mark-to-market volatility risk. GE in addition to Siemens offering structural increase inward less obvious places at a much lower price? Sure, but yous mightiness hold upward downwards 5-10% inward a hateful solar daytime if people worry almost the outlook for global growth, or the size of GE's LTC insurance reserves.
This is how yous terminate upward inward a Blue Planet where many markets are expensive, in addition to nominal long bond yields are about zero, but yous tin soundless purchase some stocks on extraordinarily depression prices - oftentimes marketplace seat leading companies amongst long term increase potential amongst dividend yields of 10%, but which come about to hold upward cyclical or plain of written report to another cast of dubiety that is inducing part cost volatility. It makes no sense, until yous recognise that most investors simply can't atmospheric condition the volatility, in addition to algobots volition dump stocks exhibiting pathetic brusque term Sharp ratio optimisations inward a self-reinforcing manner. It's also how yous terminate upward inward a Blue Planet where the vast bulk of value investors amongst keen long term records are underperforming the indices - sometimes yesteryear a sizable margin.
The outcome is that at that spot are right away extraordinary opportunities emerging inward global markets for the volatility-tolerant long term investor. The Blue Planet has a vastly excessive abundance of low-volatility capital, but a growing in addition to acuate shortage of high-volatility capital. Like all opportunities inward markets, however, the magnitude of the chance is proportional to the challenges of successfully exploiting it at scale - it is inward this abide by that markets are both highly inefficient, and offer no complimentary tiffin (something the academics missed). The chance is large because it's difficult to attract a lot of coin at the instant to implement such a strategy - most of the funds doing so are currently suffering redemptions. If it were slowly exploit, the chance would disappear. That's how markets work.
Personally speaking, I receive got the proficient fortune of beingness a small-time director amongst a depression cost base of operations in addition to my ain permanent equity uppercase invested, in addition to only demand a handful of loyal, long term investors to brand a decent living. As far every bit I'm concerned, the electrical flow surroundings is a wonderful chance if you're fortunate plenty to hold upward inward a seat to exploit it.
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