In the AFR this weekend I write that a reasonable proposition might be to suggest that in the modern history of humanity, asset prices have never been more distorted or removed from fundamental assessments of fair value. Click on that link to read the column or AFR subs can click here. Excerpt enclosed: 

It should be now well-understood that we have shifted quite radically from the freely-functioning markets that characterised the proliferation of open democracies and capitalism in the period after the second world war to a radical new regime. That is, one defined by policymakers’ realisation that when market signals do not suit them—or more particularly convey very bad news about the economy—they will manipulate those markets until they get the outcomes they desire. 

They can do so because of the monopoly central banks have over the creation of money. With the ability to manufacture unlimited quantities of money, central banks have become understandably enamoured with their ability to manage all asset prices ranging from government bonds to equities and property through direct purchases of whatever investments they want to directly exercise influence over to both boost their prices and indirectly impact others.

As just one example, the US Federal Reserve is currently buying government bonds, residential mortgage-backed securities, corporate bonds, and high-yield, or junk, securities, in the new issue market, in the secondary domain, and through exchange traded funds. The next cab off the rank would be the Fed buying equities, which is not as far-fetched as it might seem. Its much more disciplined Antipodean cousin, the Reserve Bank of Australia, has limited itself to buying federal and state government bonds, which we called for in May last year.

Capitalism seemingly cannibalising itself via embracing central planning is profoundly ironic in the face of the new Cold War between China and the West over the future of the world. The differences between the two socio-economic systems are not nearly as great as they were prior to the advent of extreme market-manipulation as a result of the 2008 shock.

In policymakers’ defence, the great virus crisis of 2020 was absolutely a picture-perfect case study for the use of these interventions in the short-term. The risk of course is that they will never be withdrawn. With the explosion of government bond issuance required to fund ballooning fiscal deficits, central banks will have no choice but to keep a lid on public borrowing costs through ongoing long-term purchases of these assets (aka QE). The alternative would be an explosion in government bond yields, or long-term interest rates, which would blow-up all asset-classes by forcing them to clear at truly unfettered prices miles below current levels.

All of this begs the question: do you want a lot of passive exposure to manipulated asset prices in your portfolios? It certainly raises an interesting challenge for the "efficient markets hypothesis" that forms the basis of so much passive, or indexed, investing today. How can markets be efficient, or the most accurate available signals of the true value of an investment, when prices are being set by unelected bureaucrats that are unilaterally deciding where they want bond yields and equity valuations to trade?

The corollary of the unprecedented global manipulation of asset prices is that markets have never been more inefficient as judged by the distance between current prices and the intrinsic valuations that would otherwise prevail under a freely-functioning regime mostly removed from central bank influence.

Don’t get me wrong: markets are extremely efficient at pricing in this market-manipulation, and the vagaries of central bank decisioning, in real-time. But they are not doing the job that they were designed to do, which is to optimally allocate scarce human and capital resources to their best use through ruthlessly accurate price signals.

So you do want passive market "beta" in your portfolio if it is a means for actively exploiting opportunities associated with central bank interference. It was pretty obvious that the extreme QE in March was going to crush the cost of capital and drive-up the value of beta globally. If you understood this, you absolutely wanted to aggressively load-up on liquid beta to capitalise on the profound price appreciation that would inevitably follow.

A second corollary is that with central banks controlling markets, beta may not behave like you expect it to. With arguably the biggest demand shock since the great depression hitting the global economy in the first two quarters of 2020, many investors expressed utter disbelief about the equities rally. On a purely fundamentals basis the sharp increase in shares did not make sense. But if you then overlay central bank control of asset prices through unrestricted QE, it was easier to understand. Put another way, it was rational to think about seemingly irrational price action.

Perhaps the biggest lesson for me is that you cannot be set-and-forget in portfolio construction when markets are more inefficient in respect of fundamental valuations than they have ever been before. You want to try and actively exploit these inefficiencies, which are a tremendous opportunity (in addition to being a portfolio threat) day-in, day-out.

The former chief investment officer of WorkCover, Jerome Lander, now runs a diversified, multi-asset class portfolio that only uses active managers. In the 12 months to June, Lander’s Lucerne Alternative Investments Fund returned 8.1 per cent net of fees compared to the 10.4 per cent loss in Aussie shares (including dividends) and the 3.9 per cent gain on AAA rated Aussie government bonds. “The world is changing rapidly and drastically, and if you’re investing in a strategy that hardly ever changes its positioning, you’re going to suffer,” Lander says.

He highlights others who have employed avowedly active approaches with similar success. “Look at the top-performing super fund in Australia in the diversified fixed-income category: it has beaten the second-best peer by 100 basis points per annum, and smashed its benchmark, over the last three years through only using very active fixed-income managers,” Lander says.

This is not to say that holding passive beta is in any way a bad thing. As noted earlier, if you can predict policymakers' behaviours, you can actively leverage that beta to your benefit at different points in the cycle. There is, therefore, a valuable role for those beta building blocks, but not necessarily for reasons that are most commonly imputed to them.

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Will Dunlop

Dear Christopher, As an avid fan of your work and writings, to quote Ali G, ‘restecp’. And as an aside, whilst your obvious erudition, and dominance of the active credit industry no doubt portends a further glittering rise, I can’t help but feel that as a devotee of markets, your true calling is the artisanal workshops and seances of the equities world. Nonetheless, your stature and abilities aside, I also can’t help but feel that, to quote a recently published Global Times piece, this article is but a ‘smash and grab’ for more actively managed fees. It mauls market pricing, and discredits your own assertion that in March certain credit instruments were mispriced too low. Given the co-dependence of asset prices, many, many assets were therefore mispriced too low, and now, they’re not? Your benefit is now the market’s absurdism. Tut tut. But good luck to you in this endeavor. Cutting to the chase, have markets ever not been manipulated by those who have the power to do so? Did dogmatic adherence to the gold standard -fixed currency pricing - not cause the Great Depression, and World War 2? Were the nationalistic bondholders of Southern Europe not given a toweling in the 1890s banking crash, as their wild optimism caused a classic credit cycle that as always, benefited those issuing, rather than subscribing? Wasn’t the 2000s bull market just a reflexive response to Greenspan’s timid put? Aren’t markets always a reaction to new news, rather than the dominant price setter that purist academics wish they were? There’ll be winners and losers. And everyone, by definition, can’t be a winner. So choosing the passive middle ground ain’t too bad, by definition. Hasn’t Jay Powell followed his mission to a T, and dotted i? The Fed’s mandate is of course to reduce unemployment, not price assets according to yesterday’s circumstances. Yesterday was always more comfortable than today, even though it wasn’t. But most importantly... aren’t market assets now perfectly priced, given all available information? Effective vaccines will arrive soon, and in abundance. The virus will almost certainly be mitigated, and interest rates are very, very low. As you often write, this virus is a blip, no? And, money is close to free. In the race for more AUM and plaudits, more adherence to reason and reality would be welcome by your readers. Yes, we rank below prospective clients, but we’re still stakeholders. Outtie.

Christopher Joye

I wrote above: "Don’t get me wrong: markets are extremely efficient at pricing in this market-manipulation, and the vagaries of central bank decisioning, in real-time. But they are not doing the job that they were designed to do, which is to optimally allocate scarce human and capital resources to their best use through ruthlessly accurate price signals."