Relax. Lunch is on… You

September 29, 2014

Remember what your mother told you about free lunches?

In my more cynical moments, I think of the “no free lunch” concept as a quaint relic from back in the day when we actually left our desks… before Seamless and artisanal coffee and being glued to 24-hour news cycles on Twitter. Because in some very powerful corners – like the most powerful corners – of the financial sphere the myth of the free lunch is alive and well.

One of the greatest hedge fund managers of our day, Howard Marks, spends the entire 16 pages of his most recent letter elaborating on the fact that risk is everywhere. It comes in so many shapes and sizes that we get quite creative to describe it: black swans, tail risk, liquidity risk, volatility, credit risk, systemic, etc. Which is why it is really bizarre that we live in a world where the most powerful arbiters of financial power in the universe ignore its existence.

By now you probably know I’m speaking of some venerable institutions: the U.S. Federal Reserve, the European Central Bank and the Bank of Japan. 

All three are run by accomplished academics, and the academic textbooks define things clearly enough: when calculating the discount rate one should use in evaluating an investment, one should multiply the market beta times the market risk premium and add this to the *RISK FREE* rate. Magic.

Smart people might argue that having the ability to print money and create currency out of thin air means that Central Bankers really *can* rely on this concept of zero risk – if they can print dollars to pay back creditors then there literally is no scenario where they can’t make good on those obligations.

As intelligent as such people might be, they ignore basics, like the idea that the Central Bank is a creation of the Federal Government and that said government has to be 1) in power, 2) supportive, and 3) financially stable. We could follow this rabbit hole further and consider doomsday scenarios like nuclear war, but there is plenty of risk to be found in more normalized situations.

Even if Japan and the U.S. are truly “risk free” in some fundamental sense (which I strongly doubt), the picture in Europe is much more black and white. It is literally against ECB President Mario Draghi’s mandate to print securities to pay back obligations of member countries in the EU. And yet, utter the word that he stands ready to support and the market turns to listen…right? Well, kind of. 

There is a significant chunk of the “market” (a term as slippery as “risk free”) that has no choice but to listen to Mr. Draghi: I am referring to the 20 trillion euros worth of bank assets subject to the ECB’s regulatory regime. This is an enormous pocket of demand that is governed not by markets, but rather by an increasingly directional and harsh regulatory regime that is currently administering a “stress test” whose results are expected in October. To pass the test under the framework of the new Basel accords, banks are required to hold more “low risk” securities like government bonds. 

What does this have to do with free lunches? 

Even prior to this recent round of stress tests, global bank asset holdings of securities like sovereign bonds had increased over 2.5% between 2011 and 2013, which equates to about $1 trillion in dollar terms since the U.S., Japan and Europe hold about $40 trillion in bank assets between them.

Quantitative easing has contributed both directly and indirectly to this massive uptick in bank holdings of sovereign credit. Just last week, the Economist reported that: “The Bank of Japan is buying around 70% of all newly issued Japanese government bonds (JGBs).” That’s not the end of the story, though: Let’s assume you are a bank in Japan and you want to hold something with “low risk.” Now that the BoJ is buying almost every newly issued JGB, you need to turn elsewhere. Luckily the markets are global, so you turn to…

The U.S. treasury market? Germany? The UK?

This phenomenon is of more than mere academic interest. In fact, the artificially low rates perpetuated by central banks are the fundamental driver of the so-called reach for yield that we see cascading across asset classes world-wide.

And it feels disturbingly familiar. In the nineties and early aughts, creative bankers in New York practiced their own techniques for transforming risky assets into “risk free” form — AAA credit, anyone? This was the ultimate free lunch. Until it wasn’t.

Fast-forward to today. Only 7 years later, and here we are again.

Global capital allocators are purchasing securities with the assumption that these securities are safe. They are accepting almost no compensation for the real risks they are taking and they are literally being forced to do so in some cases by the very regulators that are creating the low-return environment we find ourselves in.

Yes, I am really equating sovereign credit markets today to U.S. housing in 2007. Except I wish it were that simple. I think it might actually be worse.

So far, I have relegated the moniker of “risk denier” to the Central Bankers who rescued us from the last crisis. Unfortunately the free-lunch crowd is far, far bigger.

We see it in many places. In the sovereign credit markets writ large. In the high-yield bond markets where absolute yields are at all-time lows. In the mortgage market (it would be funny if it weren’t so scary that it is happening here again of all places!). And perhaps worst of all, we see it in the dominance of the so-called “passive approach to investing” that has been championed by the likes of Jack Bogle of Vanguard for so many years.

Mr. Bogle is—of course—correct that one should not charge for active investing that destroys value. However, this concept has been put on steroids and pumped to a wider audience. Passive investing has become the rage of the day, as have other forms of “cheap and easy” ways to make money, such as “smart beta.”

The “risk free” mindset that has been hammered into us by the Central Bankers’ collective bid across credit markets has rippled its way through the system and now comes in the form of strategies with 5-year track records built on pure luck.

So, let’s assume that whoever came up with the saying about “free lunches” is right, along with Mr. Marks and Schrodinger and whoever else is warning of the profound depth of uncertainty in our world. If that seems as plausible to you as it does to me, I would encourage you not to accept easy solutions. They are at best a mirage and more likely something far worse. They are a flimsy mask for hidden risks that will later emerge in potentially catastrophic ways.

I would suggest that there is no one ideal solution or strategy as we face the very real possibility of an unwind of the first and second order effects of the collective stimulus buoying global markets. I believe that more creative approaches, where talented managers operate unconstrained by artificial constructs like style boxes, have the best chance of protecting the wealth of individuals and institutions as we navigate this uncertain period. To be sure, it’s possible that your active portfolio manager will miss the indications that the free lunch buffet is about to close. But your index fund is guaranteed to get stuck with the bill.

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