Weekend Reading #36

Photo by  chuttersnap  on  Unsplash

Photo by chuttersnap on Unsplash

Obanno: Do you believe in God, Mr Le Chiffre?

Le Chiffre: No, I believe in a reasonable rate of return.

Obanno: I want no risk in the portfolio.

Le Chiffre: Agreed.

Casino Royale (2006)

If there’s one thing investment managers hate and fear in equal measure, it’s being accused of style drift. 

Deviating from the style prescribed by your investment mandate is a cardinal sin. But far worse is when managers who are laser focused on maintaining style and exposure unwittingly drift up the risk spectrum, exposing their investors to greater risk than intended. For lack of a better term, let’s call it ‘risk drift’

Risk drift is deeply troubling. And it’s everywhere you look right now. 

A permanent emergency.

The cause is simple to diagnose – persistent low rates have distorted our perception of risk. 

An emergency response has turned into permanent policy, something that critics of current Fed, ECB and BoE policy continually bemoan. Yet, as interest rates on everything from savings accounts to high yield debt continue to edge down, investors have begun mimicking warlord Steven Obanno in Casino Royale, who doesn’t ask for much from his sinister private banker – merely a ‘reasonable rate of return’ for ‘no risk’.

It seems that a low absolute rate of return is the new normal, systematically higher risk-taking is the new natural, and the level of the stock market is now the all-important barometer for economic success and stability.

The normalisation of extreme risk.

The past decade has seen a glacial drift towards blind acceptance that everything is relative. As a result of a supposed new world order of systemically lower market risk, everyone should be comfortable moving into riskier investments to pocket higher returns. And many, many investors have unwittingly taken on those risks.

We know that over the past decade or so, asset allocations have been shifting steadily in favour of greater risk, as exotic investment strategies become normalised in the zeitgeist. Only ten years ago, the idea of having savings fully invested in markets would have been sacrilege – now it’s orthodoxy.

The data corroborates our hunch that the perception of risk – and the behavior of investors – has been distorted. Consider findings published by the American Association of Individual Investors, which show that individual investors are running above-average asset allocations on both stocks and bonds, while holding much less cash than the historical average.

Source: American Association of Individual Investors, Annual Asset Allocation Survey (   https://www.aaii.com/assetallocationsurvey   )

Source: American Association of Individual Investors, Annual Asset Allocation Survey (https://www.aaii.com/assetallocationsurvey)

Source: American Association of Individual Investors, Annual Asset Allocation Survey (https://www.aaii.com/assetallocationsurvey)

Within the fixed income space, risks taken by investors have also risen. The extreme view that junk credit should make up a strategic, long-term allocation in portfolios seems to be gaining popularity, and european credit investors in particular have seen the face value of investments in sub-investment grade credit, including CLOs and other structured instruments, balloon over the past decade. More risk, more reward, at least while the music continues to play. The picture is the same in the US, with none other than insurance companies and mutual funds holding the largest chunk of structured CLO products (1).

What was once the preserve of the bravest gunslingers of the financial Wild West is now standard issue for everyday investors – with high yielding instruments and illiquid VC/PE investments strongly sought after by many, in particular pension funds looking to plug growing deficits.

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(Over)reaching for yield.

The distortion of risk in the market is concerning. 

In their 2018 study of risk premia on high yield vs investment grade credit (2), researchers Berndt and Helwege found that adjusting for known factors like systematic default risk, mis-measurement of expected losses and market liquidity, a zero-lower bound interest rate environment leads to residual risk premia for high yield debt lower than that of investment grade debt, consistent with a scenario of the market ‘reaching for yield’.

Most incisive was a paper published in 2018 entitled ‘Low interest rates and risk taking: Evidence from Individual Investment Decisionsby Lian, Ma and Wang (3), which described a series of behavioural finance experiments seeking to determine if low interest rates lead to investors reaching for yield. The results: individuals facing lower absolute interest rates become disproportionately more risk loving in order to seek out a higher absolute total return on their investment portfolios. It concludes that holding risk premia constant, individuals in a lower interest rate environment tend to take much more risk in their investments, seeking to attain a certain minimum level of return regardless of market conditions.

Not only do individuals end up making more risky investment decisions in the search for returns, they also rapidly move up the risk scale as rates fall. Moreover, framing and points of reference are important – when a high rate environment preceded a low rate environment during the aforementioned experiments, risk taking increased much more significantly, suggesting that anchoring effects, first described by Kahneman and Tversky in their various papers are also strongly at play.

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Source: Lian, Ma and Wang (2018), Low interest rate and risk taking: Evidence from Individual Investment Decisions

These outcomes suggest that the search for returns by investors is returns satisficing rather than maximising, driven more by an implicitly targeted minimum return: below a certain level, more risk will be sought to satisfy that minimum; above it, risks can be dialled down quickly. Results were uniformly unidirectional. Lower rates led to dramatically higher risk-taking. Results from a similar experiment conducted in the Netherlands by the Dutch Authority for the Financial Markets (AFM) in August 2017 (4) were unsurprisingly similar – investors in a low interest rate environment chose to take on disproportionately more risk in their search for returns.

Turns out that while the prevailing narrative purports that our returns expectations are relative, our inherent tendency is to seek out absolute returns.

Two levers. 

Our expectations of returns are (in theory) a function of the types of risk that we are willing to take. That leaves us with two levers to pull – either adjust risk to attain a given target return, or adjust return expectations while constrained by a target level of risk. The former suggests a returns targeting approach. The latter suggests a risk targeting approach: and an imprecise one at that, where investors choose a level of risk and gain exposure through a corresponding asset class type based on traditionally-accepted risk/return characteristics (e.g. equities are high risk, fixed income is low risk).

Traditionally, fixed income allocations offered a ‘fixed’ return (the clue’s in the name) and minimal capital downside, so long as the issuer remains solvent. Today these instruments offer neither sufficient yield (return) nor sufficient cushion in terms of capital (risk) as the pricing has moved so aggressively. Given the increasingly cavalier attitude of investors towards high yield fixed-income, we’re increasingly convinced that the current landscape makes for the textbook example of risk drift.

The result of the risk targeting approach, popularised by passive tracker instruments, implies that investors are supposedly willing to accept whatever the market delivers to their chosen asset allocation strategy, come rain or shine. Conversely, we are of the view that the demand for returns from most investors is absolute and will not accept big losses: hence our focus on absolute return targeting and a performance only approach to fees.

The right target.

Does any investor aim to lose money? Probably not.

An investor’s target return is naturally a specific number – a cash value that covers annual expenses, translating to a specific percentage return on a given asset base. This is absolute by any measure, since whether the market goes up or down, bills and expenses still need to be paid, and those numbers are absolute (and firmly above zero). 

Yet aside from largely logical analogies, we have struggled to comprehensively articulate the idea that most investors seek absolute, rather than relative, returns, and that the correct substitute for a savings account (which used to be the de facto savings channel for most individuals) must be an absolute return strategy with limited downside. 

When markets are rising, the debate centres on which strategy performs better on a relative basis. When markets are falling, there’s no debate to be had on relative performance – no investor wants to lose money. Some say they would be happy to accept a ‘small drawdown’ – but how small is small? And for how long would they tolerate being in the red? We suspect the answers are ‘pretty small’ and ‘not for long’. 

‘Reasonable’ is ‘absolute’. 

Given a choice, no investor would invest to ‘lose less’, especially when there exists the oft-forgotten option of ‘losing nothing’ and staying in cash, even if it yields zero. ‘Reasonable’ is, in reality, absolute. Investors want a positive return, and rightly so. 

For most individual savers and investors, the simple aim of saving and investing is the holy grail of passive income – earning an income off an existing asset base that’s sufficient for retirement without having to engage in further employment. But poor market performance isn’t an excuse for not being able to pay dollars for goods and services – costs of living remain absolute, which means they require absolute returns. 

This is the disconnect between an absolute reality and the gospel of relative returns. The ubiquitous imperative to ‘own the market’ (intentionally or otherwise) normalises the notion that a passive investment vehicle is the natural place for savings to reside, rather than a savings account with a fixed, absolute interest rate, guaranteed by the credit of the bank.

The vast majority of investors thus face a grim choice – face near-zero (or even sub-zero) savings returns from their bank accounts, or take on the full force of the market’s gyrations with off-the-shelf investment instruments in their search for higher returns. 

A marketer’s dream.

Asset managers have always had to choose between targeting returns and targeting risk. What’s new is that they’ve shifted to targeting returns without adequate consideration of how this behaviour affects risk perception amongst their investors.

Reaching for yield works like a charm for fund managers seeking to raise assets: as pointed out by Choi and Kronlund in their 2017 study ‘Reaching for Yield in Corporate Bond Mutual Funds’: (5)

We find that funds generate higher returns and attract more inflows when they reach for yield, especially in periods of low-interest rates. Returns for high reaching-for-yield funds nevertheless tend to be negative on a risk-adjusted basis.’

When income funds trot out fund strategies that involve ‘safe’ yielding investments as opposed to ‘risky’ investments like growth equities, and reallocate from high yield bonds to dividend paying equities for a yield uplift, they believe themselves to be risk targeting in sticking to their mandate. In reality, they have unknowingly (or at least unintentionally) moved up the risk spectrum to take on more risk for their investors than previously anticipated. 

The truth is that many income funds market themselves as risk targeting when their behaviour is implicitly returns targeting. And they aren’t even aware of the risk drift.

What does this all mean?

These developments have taken place gradually over the past decade, fuelled by persistently low interest rates and central bank liquidity provision. Academic research is only now starting to shed light on the psychology and behaviour of both investors and investment managers in a prolonged low rate environment. Subtle shifts in behaviour and perception have denatured the investment landscape – correlations in and across markets have risen, while opportunities for returns have diminished, leading to disproportionately more risk being taken for much lower potential returns. 

We don’t know what the end game will be, but we suspect you’ll be hearing more about risk drift in the months and years ahead.

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  1. FEDS Notes, Who owns U.S. CLO Securities?, Liu & Schmidt-Eisenlohr (2019), https://www.federalreserve.gov/econres/notes/feds-notes/who-owns-us-clo-securities-20190719.htm

  2. Berndt and Helwege (2018), How does Low for Long impact credit risk premia?, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3285510

  3. Lian, Ma and Wang (2018), Low interest rate and risk taking: Evidence from Individual Investment Decisions, https://economics.mit.edu/files/12105

  4. Ma and Zijlstra (2017), A new take on low interest rates and risk taking, https://voxeu.org/article/new-take-low-interest-rates-and-risk-taking

  5. Choi and Kronlund (2017), Reaching for Yield in Corporate Bond Mutual Funds, https://doi.org/10.1093/rfs/hhx132

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What we're doing.

The work of Israeli-American psychologist and economist Daniel Kahneman has had a big influence on how we approach our business.

His work (along with Amos Tversky) on ‘inside views’ and ‘outside views’ teaches us that when we're on the inside of a project we have a tendency to overestimate our chances of success. We’re optimistic and we overestimate how much we can achieve - and underestimate the time, blood, sweat and tears it will take to attain our goals. We focus on our specific circumstances and search for evidence in our own experiences. But extrapolating from past events is a mistake.

Kahneman calls this the ‘planning fallacy’, and many a company has failed thanks to the inability of founders and management to step outside themselves and see things from new perspectives.

Taking the ‘outside view’ and learning from the experiences of others who have attempted similar projects can help us make better decisions ourselves. Whilst we believe that what we're doing with Three Body Capital is uncharted territory for the investment management industry, we are not arrogant enough to believe that we can’t learn from others.

So, this week we’ve been catching up with friends old and new to seek input on our diversified approach to building a fund management business. Whilst everyone is different and unique, people in our network all share the same salient characteristics – they are kind, and they are VERY smart. We will certainly rely on both qualities, in equal measure, if we are to succeed in our ambitious mission.

Those of you who have taken the time to share your advice with us, thank you. You know who you are.

What we're reading.

It’s not surprising that Facebook has acquired CTRL-labs, the NYC based startup that specialises in allowing humans to control computers using their brains.

It might sound like the stuff of science fiction, but real progress is (apparently) being made. And $500-$1bn (which Facebook is rumoured to be splurging on the company) is a small price to pay for such an incredible prize. It has the potential to literally change the way that people interact with the world. According to Facebook’s Head of Consumer Devices, the technology could work something like this:

“You have neurons in your spinal cord that send electrical signals to your hand muscles telling them to move in specific ways such as to click a mouse or press a button,” Bosworth wrote. “The wristband will decode those signals and translate them into a digital signal your device can understand.”

We’ve been following the progress of CTRL-labs for a couple of years, and this transaction doesn’t surprise us one bit. It’s another huge win for Josh Wolfe’s Lux Capital, too.

Aside from paradigm-smashing neural interfaces, this week we’ve also been burying ourselves in an incredible (kind of) biography of Chairman Mao entitled, ‘Private Life Of Chairman Mao: The Memoirs of Mao's Personal Physician’. This came to us as a recommendation from BaldingsWorldBlog, who writes about China and money on Twitter.

The book is extraordinary. For 22 years, Dr. Zhisui Li was Mao’s personal physician, confidant and companion. He had a front row ticket through the years of the Great Leap Forward and the Cultural Revolution, and the book elucidates Mao's relations with other world leaders – and the psychological shift that led him to turn against the Chinese Communist Party's ruling clique. We also learn about Mao's private life: his carnal appetites, the luxury and corruption of his imperial court, and his gradual disintegration.

One Amazon reviewer called it ‘grimly mesmerising’ – we tend to agree.

Finally, as huge Led Zeppelin fans we also clocked this piece in the New York Times. For the past five years, the bands totemic hit ‘Stairway to Heaven’ has been caught up in a copyright infringement case that has gripped the music industry and fans everywhere. Next week, a panel of 11 federal judges in San Francisco will delve into the song’s authorship.

Recent legal cases involving ‘Stairway to Heaven’, ‘Dark Horse’ and Robin Thicke’s (frankly terrible) ‘Blurred Lines’ have raised serious questions about which musical elements can be protected by copyright, calling into question what constitutes an original artwork. This might seem niche, but at stake is something much bigger – the very nature of authorship.

What we're listening to.

Despite incredible advances in video, VR and AR, audio remains a key channel for enjoying content. It just works so well with our busy, modern lives, enabling us to commute, work, exercise, cook, care for our children and generally multi-task whilst listening to brilliant stories and improving our knowledge of the world around us.

As you probably (definitely) already know, we’re addicted to podcasts. But we also rely on Audible for long-form fiction and non-fiction.

And now there’s Curio. It’s an app that lets you listen to professionally narrated articles from premium publications like The Financial Times, The Guardian and Aeon. This solves a big problem for us (not enough hours in the day to binge on journalism). We’ve been trialling it this week and so far, so good!

Weekend ReadingEdward Playfair