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Simple Index Funds May Be Complicating the Markets - Fullermoney
This is an interesting and topical column (may require subscription registration) by Jason Zweig for The Wall Street Journal. Here is the opening:
Index funds are often hailed for their low fees, solid performance and transparency.
Could they also be destabilizing the markets-and undermining the very diversification they have long promised?
Recently, leading investing experts-including Rodney Sullivan, editor of the Financial Analysts Journal, consultant James Xiong of Morningstar Investment Management and Jeffrey Wurgler, a finance professor at New York University-have been warning that index funds could destabilize the financial markets.
The rise of trading in index funds, these researchers say, is causing stocks to move more tightly together than ever before-as if they "have joined a new school of fish," as Prof. Wurgler puts it. That is reducing the power of diversification and could make booms and busts more likely and more extreme.
Unlike conventional funds run by highly paid stock-pickers who seek to buy the best securities and avoid the worst, index funds-including most exchange-traded funds, or ETFs-effectively buy and hold all the securities in a market benchmark such as the Standard & Poor's 500-stock index.
My view - In recent years I have felt that high frequency algorithmic trading - also mentioned in the article above - was the most important factor behind not only the unprecedentedly high correlation among financial assets but also much of the volatility seen. There have been many reports attributing over 60 percent of the trading volume on Wall Street to HFT.
However, it is also logical that the proliferation of index tracking funds would contribute to equity correlation. Combined, HFT and tracker funds have led to the 'risk on' and 'risk off' descriptions of market volatility which so unnerved investors last year.
Is this another 'new normal' or could markets revert to their earlier, less correlated characteristics of the pre-2008 period?
This item continues in the Subscriber's Area.
Tim Price: The Great Repression - My thanks to the author for his sagacious letter which this week address the unpleasant topic of financial repression. It is posted in the Subscriber's Area but here is a brief sample:
The chart above confirms that US corporate profits have now reached record levels as a percentage of GDP. They are unlikely to stay there. Napier suggests, perfectly logically, that when the government needs money to fund itself, it will target those constituents that actually have some. That is, in other words, wealthy individuals and corporations.
What will be awkward about this financial repression of the moneyed classes, if it comes (which it surely will), is the timing. Well, not just the timing, but the yields on offer consistent with that timing. With the benefit of hindsight it would have been no bad thing to be coerced into buying US Treasuries when they yielded, say, 16% (the chart below shows generic 10 year yields going back to 1979; source: Bloomberg). But now that they yield 2% or so (a negative real yield of 1% or so using official inflation data), well, who wants that ? Answer: not foreign central banks, many of whom have stopped buying this yieldless junk.
And:
In an NBER paper last year, Carmen Reinhart and M. Belen Sbrancia pointed the way. As their abstract states,
"Historically, periods of high indebtedness have been associated with a rising incidence of default or restructuring of public and private debts. A subtle type of debt restructuring takes the form of "financial repression". Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between governments and banks.. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation."
My view - Western Autonomies have anticipated the risk of financial repression and it is a key reason why they have preferred to keep overseas earnings overseas.
This is certainly not the first time that desperate or ruthless governments have resorted to financial repression, and it will not be the last. At least we have recourse to the ballot box in democracies and if that does not work we can always flee to The Best Exotic Marigold Hotel. You would probably enjoy the film, if not the solution.
A good report on asset reflation - My thanks to a colleague for this report which is in line with Fullermoney views. It is posted in the Subscriber's Area.
Five Reasons Europe Looks Less Disastrous - This is a good summary by Christopher Power and Simon Kennedy for Bloomberg Businessweek. It is posted in the Subscriber's Area but here is the introduction, plus what I think is the most important of their five reasons:
Optimism has not been an emotion experienced by too many Europeans of late. Yet that positive feeling is creeping into the markets. The big stock exchanges in Europe are all off to strong starts this year: The Dax index of German stocks is up 16 percent. Even the Athens stock exchange is up 21 percent. The bond markets, meanwhile, are easing borrowing costs for Spain and Italy, with yields below 6 percent on 10-year bonds. An impressive performance, considering the euro crisis is far from over and a risk still exists that Greece won't have the money to pay bondholders come March 20.
So why the sunnier feelings? Investors have a lot of reasons, some of them contradictory. They all show how far Europe's markets have come since the onset of the crisis in late 2009. There are five in particular:
• The European Central Bank's newfound willingness to lend banks as much money as they want for three years is proving very effective in supplying Europe's financial system with extra liquidity. The longer-term refinancing operations (LTROs) allow Europe's banks to post iffy collateral-like the banks' holdings of Greek sovereign debt-with the ECB, which provides cheap loans in return. The three years are long enough to bridge the crisis, and the money gives the banks time to improve their balance sheets and boost their own lending, the ECB hopes.
My view - Obviously Europe's problems have not been resolved but they have been contained in ways that few people dared hope in 4Q 2011. That is a form of progress and it has been reflected by stock market performance.
Please note - Eoin is in Guangzhou and Shenzhen this week and will return to the office on February 27th.
