Equity prices in continental Europe and emerging markets, including China, are below fair value, and present an opportunity for investors, but the ‘entanglement of risk’ in current markets is making Brian Singer, partner and head of dynamical allocation strategies team, William Blair cautious.

William Blair typically targets around 10 per cent volatility in its portfolios, but at the moment it is taking below average risk, with volatility around 6 per cent.

“We are very cautious right now,” Singer said.

“The entanglement of risk – commodity prices, China growth, Europe, and Fed policy – leads us to be more cautious than would otherwise be the case,” he says.

The two areas in global equities that he does see opportunity are continental Europe and emerging markets.

Over the long term William Blair thinks that China’s growth will be around 5 to 7 per cent.

“China’s growth is slowing and the world collapsed. That is not a sustainable approach.”

“In the short term if the market is focusing its attention on a 3.5 per cent reduction in China’s currency then we think that is an opportunity.”

However while the prices are below fair value, and present an opportunity, there is too much uncertainty and opaqueness.

“Fundamental value is a long-term concept. It is important to know what the economy is doing over the long term, but in the short term you can take advantage of the market’s mis-perception.”

Singer says that increasing geo-political instability and the interconnectedness of risk means investors need a deductive framework to deal with information.

“Most investors think indeductively, they see patterns from history. So how do we get context in a world that’s complex and inter-related,” he says. “There is a diminishing marginal return to information, as you get more information your confident increases even though the information is not more useful.”

Instead he advocates for an inter-related framework to assessing investment opportunities which looks at fundamental value, which is not driven by history; market behaviour analysis, in order to understand why prices deviate, this explained by game theory; and risk capital allocation.

“We identify macro themes, and create propositions that are affecting prices. These might include the commodity super-cycle, China’s growth or populism,” he says. “I defy you to understand Donald Trump, but he is a rejection of the established elite. People don’t believe what the established elite is saying, it doesn’t mean they believe Trump though.”

Populism was a theme that played out in Europe, with Singer saying that populism was the biggest threat to the Eurozone and stopping it has been one of Germany’s motivations.

“Most of the risk is behind us and we are buying. We increased risk in all places where there was populist dissent including Spain, France, and Italy.”

Singer says William Blair does not try and forecast the economy or monetary policy, but tries to understand what the market thinks.

“Is it operating from fear or greed? If can understand that, then we can understand why prices are deviating from fundamental values.”

“When we position a portfolio our job is to take risk, but the key to take compensated risk. If you don’t understand it even if it is compensated, then it is best left alone.”

 

Brian Singer will give a keynote at The Fiduciary Investors Symposium, Chicago Booth School of Business, October 18-20

Institutional investors now dominate the free float holdings of listed companies and exchanges need to adapt to this enduring change in market structure and investor needs, according to Norges Bank Investment Management, manager of the $818 billion Norwegian sovereign wealth fund.

Norges Bank, which itself owns around 1 per cent of the world’s listed stock, says that exchanges remain critical to well-functioning markets and provide a valid function as listing venues and as the final arbiter of prices discovery process.

However they need to adapt and innovate to enhance their attractiveness to institutional investors which have supplanted the many retail investors that the system was set up to serve.

One of the implications of the change in investor base is there are fewer but larger trades.

A Central Limit Order Book, which his pre-supposing the existence of continuous two-way liquidity supply and demand, may no longer be the optimal mechanism for price discovery.

“Block-crossing venues, the increasing attractiveness of end-of-day auctions, and changes in the intraday volume distribution are all an expression of the need, and the willingness of institutions to give up continuously clearing markets in favour of on-demand but more sizable liquidity events.

“Fortunately equity markets are a long way off from the type of ownership concentration seen in many corporate bond markets. However, we believe that equity markets may be able to learn something by monitoring developments in fixed income markets, rather than the other way round.”

Norges believes one of the key propositions of exchanges is they ensure the “liquidity risk premium” is safeguarded and enhanced by encouraging private firms to go public.

However evidence shows that the number of listings has been decreasing with the number of listings in the US dropping 20 per cent in the 10 years from 2004 to 2013, and 30 per cent on the Euronext and Deutsche Borse over the same period.

Meanwhile there is a significant portion of the equity market that is not listed – from 40 per cent in the UK to more than 80 per cent in Southern and Eastern Europe.

In a whitepaper on the topic, Norges says the technology developments have provided a robust platform for exchanges to ensure efficient price discovery, even in periods of extreme volatility.

However the current latency race is ultimately a dead-end, the paper says.

“We welcome initiatives taken by exchanges to increase availability of liquidity in size. Supporting the developments of batch auctions and experimenting with size versus time priority models are all initiatives in the right direction, in our view.”

Norges Bank has started to shift to more block executions, a reflection of increased willingness to take on opportunity cost in exchange for lower market impact cost.

 

To access the white paper click below

Role of exchanges in well functioning markets

The US Federal Reserve is not paying enough attention to secular forces affecting the market, according to chairman and founder of Bridgewater, Ray Dalio, who says the “risks of the world being at or near the end of its long-term debt cycle are significant”.

In an opinion piece posted on LinkedIn, The Dangerous Long Bias and the End of the Supercycle, Dalio says “we believe that is more important than the cyclical influences that the Fed is apparently paying more attention to”.

In the article he says interest rates around the world are at or near 0 per cent, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high.

“As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant. That is what we are most focused on.”

Dalio says that since 1980 every cyclical low in interest rates and every cyclical peak was lower than the one before it until interest rates hit 0 per cent, when quantitative easing needed to be used instead.

“That is because lower interest rates were required to bring about each new re-leveraging and pick-up in growth and because secular disinflationary forces have been so strong (until printing money needed to be used instead).

“We believe those secular forces remain in place and that that pattern will persist.”

 

 

The full, unedited, article is below and can be accessed on LinkedIn

Why We Believe That the Next Big Fed Move Will Be to Ease (via QE) Rather Than to Tighten

As you know, the Fed’s template and our template for how the economic machine works are quite different so our views about what is happening and what should be done are quite different.

To us the economy works like a perpetual motion machine in which short-term interest rates are kept below the returns of other asset classes and the returns of other asset classes are more volatile (because they have longer duration) than cash.

That relationship exists because a) central banks want interest rates to be lower than the returns that those who are borrowing to invest can generate from that borrowing in order to make their activities profitable and b) longer-term assets have more duration that makes them more volatile than cash, which is perceived as risk, and investors will demand higher returns for riskier assets.

Given that, let’s now imagine how the machine works to affect debt, asset prices, and economic activity.

Because short-term interest rates are normally below the rates of return of longer-term assets, you’d expect people to borrow at the short-term interest rate and buy long-term assets to profit from the spread. That is what they do. These long-term assets might be businesses, the assets that make these businesses work well, equities, etc. People also borrow for consumption. Borrowing to buy is tempting because, over the short term, one can have more without a penalty and, because of the borrowing and buying, the assets bought tend to go up, which rewards the leveraged borrower. That fuels asset price appreciation and most economic activity. It also leads to the building of leveraged long positions.

Of course, if short-term interest rates were always lower than the returns of other asset classes (i.e., the spreads were always positive), everyone would run out and borrow cash and own higher returning assets to the maximum degree possible. So there are occasional “bad” periods when that is not the case, at which time both people with leveraged long positions and the economy do badly. Central banks typically determine when these bad periods occur, just as they determine when the good periods occur, by affecting the spreads. Typically they narrow the spreads (by raising interest rates) when the growth in demand is growing faster than the growth in capacity to satisfy it and the amount of unused capacity (e.g., the GDP gap) is tight (which they do to curtail inflation), and they widen the spreads when the opposite configuration exists, which causes cycles. That’s what the Fed is now thinking of doing—i.e., raising interest rates based on how central banks classically manage the classic cycle. In our opinion, that is because they are paying too much attention to that cycle and not enough attention to secular forces.

As a result of these short-term (typically 5 to 8 year) expansions punctuated by years of less contraction, this leveraged long bias, along with asset prices and economic activity, increases in several steps forward for each step backwards. We call each step forward the expansion phase of each short-term debt cycle (or the expansion phase of each business cycle) and we call each step back the contraction phase of each short-term debt cycle (or the recession phase of the business cycle). In other words, because there are a few steps forward for every one step back, a long-term debt cycle results. Debts rise relative to incomes until they can’t rise any more.

Interest rate declines help to extend the process because lower interest rates a) cause asset prices to rise because they lower the discount rate that future cash flows are discounted at, thus raising the present value of these assets, b) make it more affordable to borrow, and c) reduce the interest costs of servicing debt. For example, since 1981, every cyclical peak and every cyclical low in interest rates was lower than the one before it until short-term interest rates hit 0%, at which time credit growth couldn’t be increased by lowering interest rates so central banks printed money and bought bonds, leading the sellers of those bonds to use the cash they received to buy assets that had higher expected returns, which drove those asset prices up and drove their expected returns down to levels that left the spreads relatively low.

That’s where we find ourselves now—i.e., interest rates around the world are at or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high. As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant.

That is what we are most focused on. We believe that is more important than the cyclical influences that the Fed is apparently paying more attention to.

While we don’t know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces. These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets—at the same time as the world is holding large leveraged long positions.

While, in our opinion, the Fed has over-emphasized the importance of the “cyclical” (i.e., the short-term debt/business cycle) and underweighted the importance of the “secular” (i.e., the long-term debt/supercycle), they will react to what happens. Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.

To be clear, we are not saying that we don’t believe that there will be a tightening before there is an easing. We are saying that we believe that there will be a big easing before a big tightening. We don’t consider a 25-50 basis point tightening to be a big tightening. Rather, it would be tied with the smallest tightening ever. As shown in the table below, the average tightening over the last century has been 4.4%, and the smallest was in 1936, 0.5%— when the US was last going through a deleveraging phase of the long term debt cycle. The smallest tightening since WWII was 2.8% (from 1954 to 1957). To be clear, while we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE.  By the way, note that since 1980 every cyclical low in interest rates and every cyclical peak was lower than the one before it until interest rates hit 0%, when QE needed to be used instead. That is because lower interest rates were required to bring about each new re-leveraging and pick-up in growth and because secular disinflationary forces have been so strong (until printing money needed to be used instead). We believe those secular forces remain in place and that that pattern will persist.

Fiduciary law, which creates the boundaries and rules for asset owners managing other people’s money, is evolving. The short-termism, misaligned incentives and complex and over-supply of services that characterises financial services, is under fire.

Regulators around the world are increasingly looking at how to change the behaviour and supply chain dynamics in the industry, and at the same time the evolution of fiduciary law is also providing something quite different – creating the distinction between doing things right or complying with the legal rules, and doing the right thing. Doing the right thing, or a guiding sense of social purpose, is what is needed if the market system is able to continue to have enormous potential.

These are the views of Ed Waitzer, who is professor and Jarislowsky Dimma Mooney Chair in Corporate Governance at the Osgoode Law School at York University in Toronto, who believes that the finance sector should be proactive in shaping the trend.

He says that the trajectory of the law is clear, that regulators and legislators (and courts) are expanding fiduciary duties based on reasonable expectations that the financial sector should serve the public interest.

In an article in the Rotman International Journal of Pension Management last fall, he and co-author Douglas Saro, who is an associate of Sullivan and Cromwell, outline five initiatives that they believe if implemented “would materially raise the perception and reality of the financial sector’s social utility around the world”.

  1. Rethink fiduciary duty. The fiduciary of the future will recognise and follow through on responsibilities to preserve and support the institutional system in which the fiduciary is embedded, including a duty to ensure that externalities are properly priced and moral failures are addressed. This will require a shift away from the zero-sum perspective that for a financial institution to win the client must lose, and toward a fiduciary culture with a clearly articulated and generally accepted public purpose.
  2. Foster win/win collaborations. This includes collaborations between investors and corporations and the sharing of costs between multiple parties.
  3. Create legal mechanisms to protect future generations
  4. Rethink regulation
  5. Reassert the social utility of the financial sector.

The article Reconnecting the financial sector to the real economy – a plan for action outlines how institutions can shift from reactive to proactive regulatory and compliance strategies.

Ed Waitzer will speak about fiduciary duty and law at the Fiduciary Investors Symposium at the Chicago Booth School of Business from October 18-20.

He will speak on a panel regarding fiduciary responsibility alongside:

Sharan Burrow, general secretary, International Trade Union Confederation

Colin Melvin, chief executive, Hermes EOS

Beth Richtman, portfolio manager – infrastructure and global governance, CalPERS

Martin Skancke, chair of PRI and chair of the expert group on investments in coal and petroleum companies, appointed by the Norwegian Ministry of Finance

www.fiduciaryinvestors.com

The impact of size is a delicate point for asset managers. For specialist asset classes, and boutique managers, being small and nimble can be a source of alpha. On the other hand, being large can reduce fees and increase innovation and product offering.

But now there is evidence to show that the emergence of the mega manager can also have an impact on the price of the stocks it invests in, other managers’ behaviour and the liquidity and volatility of the market.

Blackrock is clearly the world’s largest asset manager, at the end of June, 2015 it had $4.72 trillion in assets. According to the Towers Watson list of the world’s largest asset managers, Blackrock grew by 230 per cent in the period from 2008 to 2013 – much of that was due to the merger in 2009 with BGI.

In a well-titled INSEAD working paper, Who is afraid of Blackrock?, the authors examine the impact of that 2009 merger in the context of the stock prices of invested listed companies.

The authors estimate that stocks representing more than 60 per cent of world market capitalisation were directly affected because they were held in both BlackRock and BGI-managed portfolios prior to the merger.

In addition, the sheer size of BlackRock means that the firm is now the single largest shareholder in a large number of firms worldwide. The paper takes a close look at the impact of this concentrated ownership and how that affects the investment behaviour of other financial institutions and the cross-section of stocks worldwide.

The authors document portfolio changes by institutional investors other than BlackRock or BGI in response to the merger between the two entities, and find that in the second half of 2009, institutional investors re-balance away from stocks that experience a large increase in ownership concentration.

“We study how the investment behaviour of institutional investors is affected by their strategic reaction to changes in the degree of ownership concentration and how this affects the stock market.”

“We argue that investors are careful to hold stocks with concentrated ownership as these expose them to idiosyncratic shocks of the large owner.

“We find that other institutional investors re-balance away from stocks that experience a large increase in ownership concentration due to the pre-merger portfolio overlap between BlackRock and BGI. Over the same period, institutional ownership migrates towards comparable stocks not held by BGI funds prior to the merger,” the paper says.

More important, the re-allocation of institutional ownership has a price impact, and that stocks that experience large increases in ownership concentration due to the merger experience negative returns that do not fully revert, the paper says.

“These stocks also become permanently less liquid and less volatile.”

“Our results have important implications because they clarify the impact of concentrated ownership on stock markets and because they suggest that large asset managers may have systemic risk implications. Our results suggest that the presence of large asset managers can reduce stock volatility at the expense of lowering liquidity.”

 

To access the paper click below

Who is afraid of Blackrock

 

 

 

 

 

Funds management is often discussed in the context of it being part art and part science, however most of the literature centres around the science, the finance, of funds management.

The premise of active management is that skills and knowledge are paramount to capturing excess returns above the benchmark. But despite this premise, little is known about knowledge management in the context of asset management. The chief investment officer of APG, Eduard van Gelderen, has co-authored a paper with Ashby Monk executive director of the Global Projects Center at Stanford University, arguing that the creation, maintenance and exploitation of knowledge management is critical to the success of any investment organisation.

The paper offers insight into the role that knowledge plays in the investment process and, more specifically, into the adoption of knowledge management by asset managers. The paper concludes with a blueprint that offers a way for investors to become knowledge and asset managers.

More general research, across all industries, shows that organisations get value from knowledge management and that knowledge carries as much value as financial or even human capital. They authors say that it is the context of the organisation’s design that knowledge ultimately drives performance.

In the context of a continued low return environment, where alpha or above market returns will arguably add more to total portfolio returns than the past 30 years where passive management has been a good contributor, active management or skill and knowledge will need to be harnessed. It is a good time to be appreciating the power of knowledge management.

“Given the importance of superior knowledge in performance, you’d be forgiven for assuming that knowledge management – or how human capital, market intelligence and governance is combined… – was a top priority for all active asset managers. Oddly it isn’t. Most asset managers could not be described as knowledge managers at all.”

The authors say that despite the knowledge intensive nature of the industry many aspects of knowledge management are left implicit and are not dealt with at a structural or strategic level. The paper outlines a blueprint for how knowledge management could be better integrated into asset management.

The paper can be accessed below

Knowledge management in asset management