Saturday, 22 September 2018

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SwissInvest strategist Anthony Peters calls for a bonfire of the quants

Anthony Peters, SwissInvest Strategist

I THINK MORE or less everybody has been blamed for the sovereign debt crisis. Banks. Politicians. Banks. Welfare recipients. Banks. Property buyers. Banks. Property sellers. Well, everyone with the exception of those mathematicians and model builders who have tried to turn investment from an art into a science.

Until the early 1990s, portfolio managers largely bought what they thought looked good and that made sense to them. Some of their investment decisions proved to be ingenious, most of them were pretty indifferent and the odd one went disastrously wrong. There were, of course, the indices – the FTSE, the DAX, the DJIA, the S&P and so on, but they were just mechanisms to display market performance.

But then came the savings and loans crisis in the US and the banks got their balance sheet knickers in a twist. The Fed responded by pushing the funds rate down to 3% and there it sat. The yield curve became the proverbial free lunch and so the taxpayer funded the rebuilding of banks’ capital bases without even knowing it. The Treasury and the Fed together gave the industry a risk-free carry trade.

Unfortunately, a steep curve did not help total return investors and so, innocent as many were, they bought leveraged curve structures that gave them lovely returns until February 1994, when, after just under two years of unchanged rates, the Fed began to tighten again. Bond markets went into meltdown, total returns in the major markets were negative for the year and most investors lost money. The guys with embedded leverage went up in smoke.

Then out of the woodwork crept the quants, who explained to shell-shocked management that with their models of balanced risk the losses would have been a fraction and the only way to be safe was by taking a scientific approach to risk exposure. That their model-based approach would have massively underperformed in 1991, 1992 and 1993 never made it into the discussions. And so money managers were ordered to swap market risk for benchmark risk and watching markets was replaced by calculating tracking errors.

INDEXING OPENED A whole can of worms. Any divergence from the index weighting is increased risk. Thus, as in sovereign indices, if the weighting of a credit risk is “market cap” based, then the more a country borrows, the more paper investors have to buy.

As the credit deteriorates and as borrowings rise in absolute terms, so benchmarked investors have to buy more paper, whether they like it or not – that is if they want to be “risk-neutral”. Who gives a toss whether the credit goes to hell in a handcart, so long as the investment managers can tell their clients that they took no risk by losing all that money?

Blind quant thinking helped to give them cash they should never have had.

So the worse the credit got, the more bonds that were issued into the market, and the more investment capital had to be allocated to the country in question. It makes sense in equities to be long and longer of companies with rising market caps but how can that be reasonably applied to debt?

Investment guidelines actually prevented many investors from exiting certain markets. And it wasn’t until certain sovereign credits dropped into Triple B territory and out of some of the indices that many fund managers finally found the excuse they had been longing for – from six notches higher up – and dumped their holdings.

Let’s face it, had these indices with their market cap-weighted components not existed and had investors not been obliged to buy bonds, lots of the countries that are now in trouble would have run out of credit ages ago. Blind quant thinking helped to give them cash they should never have had.

THE CONCEPT THAT the deeper a country falls into debt and the more it issues, the more investors are obliged to lend it, is just so counter-intuitive that it should be outlawed. Instead, it’s held up as the paragon of virtuous and prudential investing.

Indices should give guidance as to what the overall market performance looks like. They should set a return benchmark to be kept in the corner of investors’ eyes, not be the Maypole around which everyone dances.

Twenty years ago, there were a number of indices that were “benchmarks” – today we have thousands of the blasted things. Add to those all of the so-called “bespoke benchmarks” (created for a single institution for a single purpose and that do precious little to help the investment managers’ clients truly compare) and the number of benchmarks will be in the tens of thousands.

If not brain-washed, the boards of most insurers and the trustees of most pension funds would be happy to see more in their investment accounts at the end of the year than was there at the beginning. Their liabilities don’t follow indices, so why should their assets?

The slings and arrows of rising and falling markets will never go away but to oblige portfolio managers to watch the value of their assets evaporate while being told that they have no risk because they are “market weight” just cannot be right.

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