28 September 2018
*Items marked with an asterisk come highly recommended.
How financial markets have changed
The last few years have seen some phenomenal transformations in the financial markets. A think tank, New Financial, lists 10 of the biggest changes since the ructions started in 2007 (there’s also a full report for those interested), and CGAP (Consultative Group to Assist the Poor), lists five over the last two decades from a more development and inclusion-minded perspective.
Gavyn Davies, former government economic adviser and Chief Economist at Goldman Sachs, writes about regime changes. Since 2008, markets have been dominated by a series of economic narratives often driven by monetary policy. Quantitative easing dictated sentiment from 2012 to 2015, deflation from 2015 to 2016, growth synchronisation in 2017 and quantitative tightening in 2018. Narratives are powerful, and it’s important to know what the current flavour is, even if we don’t fully believe it.
The Wall Street Journal has an attention-grabbing series of graphics* to commemorate the 10th anniversary of the global financial crisis. Admittedly its US-centric, but it still looks neat. In a 15-minute but pacy video, Gillian Tett, of the FT, asks some of the leading figures of the crisis whether banking culture has changed since then. She concludes not really, indeed we’re left pondering whenever the next crisis does strike, whether the political system up to the job of managing it.
Building portfolios today
One of the most pervasive developments we have seen since in recent years is the breaking down of investments into factors. That trend has fuelled the growth of ETFs. O’Shaughnessy Asset Management has written a superb guide to 49 factors from scratch*. Intriguingly, it likens the value factor to New York city distressed taxi medallions and momentum to Uber cabs. Traditional taxi businesses are on depressed valuations because of disrupters such as Uber, which are riding a wave of momentum in revenue growth and excitement. But, if cashflows from medallions, which confer the right to run taxis, stabilise, they could represent a bargain.
Staying on the value theme, other than a short period in 2016, why has it underperformed for nigh on 10 years now? Low growth rates, low interest rates and the dominance of tech stocks valued on subscriber growth rather than earnings may have something to do with it. Managed Asset Portfolios, a boutique manager committed to value investing, offers a compelling argument on why you shouldn’t give up on the discipline. It revisits several historical periods including Tulip Mania, the Roaring Twenties, the Nifty Fifty, and the Dot-com bubble to show that fads eventually give way to steady cashflow generators - the value stocks.
PineBridge Investments has drawn what it thinks the capital market line looks like* - the risk versus return spectrum of all the different asset classes. The asset manager gets quite granular even signposting Peruvian local currency debt on its chart.
Financial technologist, Finastra, explains in a white paper something that we all take for granted: diversification delivers better risk-adjusted returns. The novelty of Finastra’s effort is that it argues the diversification should be on a multi-asset level and provides a high-level guide to running multi-asset portfolios covering operations, risk management, technology, compliance and organisational buy-in.
Over-achiever, Rishi Ganti (PhD, JD, CFA, CPA, FRM - making him an economist, lawyer, investment analyst, accountant and risk manager… oh yes, he also speaks six languages), explains in a podcast why the opportunity for alpha is negligible in traditional markets and the new frontier is esoteric investments* - assets without active markets or in other words non-bid, non-flow, non-auction, and non-existent to Wall Street. This includes charter school financing, factoring payments between various entities, forestry, farmland, motion picture rights, music royalties, litigation finance and fibre optic cable. Before you get carried away, this blog offers some of the drawbacks of investing in esoteric investments (essentially no-one really understands the risks).
How will markets look in the future
Bloomberg released a brilliant but potentially alarming* collection of articles at the end of last year with predictions that Blackrock and Vanguard will manage a combined US$20 trillion within a decade, AI will have a hand in 99 per cent of investing, long-short hedge funds will die out, and the future of investing lies in Asia.
Dick Bove, a five-decade veteran of banking research, warns that the economy is undergoing a fundamental change where demand for money is rising and the growth of its supply is slowing. This will make the value of the dollar fall and with it financial assets. Be afraid.
In its 2020 series, PwC lays out what the financial world will look like in two years. It’s asset management publication expects alternatives to become mainstream, mega-managers to dominate the industry and more self-directed investing from mass affluent individuals using platforms.
Forbes lists its Fintech 50 - innovative companies shaking up the world of investing. Whether it's trading apps, robo-advisers, data and analytics, peer lending, personal finance or blockchain, at least a few of these companies will become the behemoths of tomorrow.
Academic work on the subject
The boffins at Harvard discuss whether you should bet on inflation or on deflation*. The title of the paper is a little sensational. The authors look at the capacity of US treasury bonds to hedge stock returns, which boils down to the correlation between the assets. It’s often assumed that there’s a negative price relationship between stocks and ‘govvies’, and that’s been the case in the last two recessions (2001 and 2008) but it’s not the full story historically. There are periods of positive and negative correlation. The important insight of this paper is that it’s the correlation between inflation and real economic growth which indicates the bond and stock relationship. Now, if only they can come up with a model which states the relationship before the fact…
Marcos López de Prado presents seven reasons why most machine learning funds fail. Included in Prado’s list is that discretionary portfolio managers tend to work individually or in small teams which limits their influence on other managers at the firm, whereas this structure does not work for quant portfolio managers who require specialised teams to identify new strategies. Another problem is backtest overfitting where quants pick the best result from multiple configurations which results in great theoretical returns but poor outcomes in practice.
Books on the subject
The world of finance has been dominated by the debate over whether markets are rational and perfect or irrational and imperfect. In Adaptive Markets*, MIT prof, Andrew Lo, draws on biology, neuroscience and psychology to show the evolutionary reasons why investors act the way they do, and why these actions can appear totally random. Lo comes up with a new framework for looking at markets beyond arguments for pure rational or irrational behaviour, showing how they are shaped by humans’ evolutionary fight for survival over millions of years.
Black Swan by Nassim Taleb is a well-publicised book but highly relevant to changing perceptions of risk. His key insight is that we tend to concentrate on things we already know and often fail to take into consideration what we don’t know. This makes us unable to truly estimate opportunities, too vulnerable to the impulse to simplify, narrate, and categorize things, and not open enough to rewarding those who can imagine impossible events happening.
Forecasters, especially in the world of finance, have bad reputations. Superforecasters digs into what makes a good forecaster. Dan Gardner and Philip Tetlock look at forecasting competitions involving questions such as ‘What is the probability of general election being called in the UK in the next 12 months?’ and then interview and profile contestants who do exceptionally well. They also find that there is truth to the wisdom of crowds - collective forecasts tend to be more accurate than individual predictions.
Something lighter - film and fiction
We are spoilt for choice on films about how the future will look. So, in the name of progress we picked three movies set in future that we thought were better than their original versions (be warned that all are dystopian): Blade Runner 2049*, Mad Max: Fury Road*, and Dawn of the Plant of the Apes.
The White House Mess is a satirical journey following fictional President Thomas N. Tucker (initials TNT) through a term in office. In Christopher Buckley’s novel, the President is foul-mouthed, insults and threatens other world leaders, mocks journalists, and resorts to writing speeches himself that are largely incoherent. White House staffers fight for access to the President while his much younger soft-porn starlet wife shuns Washington to live in New York and avoid First Lady duties. At one point the Ku Klux Klan endorses the President’s re-election bid. The book was written in 1995 but we’ll leave aside judgement on whether life is stranger than fiction.
Highly recommended list
- 10 years after the crisis - Wall Street Journal
- 49 factors from scratch - O’Shaughnessy Asset Management
- The capital market line - PineBridge Investments
- Esoteric investment with Rishi Ganti - Invest Like The Best podcast
- The future of investing - Bloomberg
- Inflation bets or deflation hedges - John Y. Campbell, Adi Sunderam, and Luis M. Viceira
- Seven reasons why most machine learning funds fail - Marcos López de Prado
- Adaptive Markets - Andrew Lo
- Blade Runner 2049 - Directed by Denis Villeneuve
- Mad Max: Fury Road - Directed by George Miller
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