The operational frameworks of central banks have changed fundamentally in the wake of the great financial crisis. Non-conventional monetary policies have become the new normal in all large developed economies. They have created new systemic risks, such as [i] prolonged sedation of markets through containment of asset price volatility, [ii] exhaustion of scope for further monetary stimulus in future crises and [iii] addiction of economies to cheap funding. Read more
Part 1: Systemic Risk
Public debt ratios in the developed world have reached record highs. This has reduced governments’ capacity to stabilize financial and economic cycles in the future. It has also increased the dependence of sovereign debt sustainability on low real interest rates. Avoidance of excessively tight fiscal conditions and protection of sovereign solvency in developed economies partly relies on “financial repression”: a set of macroeconomic and regulatory policies that channels cheap funding to public budgets for a prolonged period of time. Read more.
Inefficiencies of financial institutions, laws, and regulation are at the heart of systemic risk. The most critical areas of financial intermediation are the regulated banking system (due to its massive leverage), the so-called shadow banking system (due to its lack of transparency and dependence on collateral values), institutional asset management (due to its massive size and rapid secular growth) and emerging markets, particularly China (due to evident inefficiencies and political context). Read more.
Part 2: Systematic Value
Information efficiency of an investment manager helps individual returns. Information efficiency of the overall market helps the economy, because market prices guide decisions of companies, governments and households. Qualified macro research is expensive; improving its productivity and translating it into factors for trading strategies is a major source of systematic value. A useful structure for such factors is to divide them into three areas: [i] fundamental valuation gaps, [ii] implicit subsidies, and [iii] setback risks to fundamentally sensible investment principles. Read more.
Price distortion-based strategies are all about tracking and responding to apparent price-value gaps. They require flexibility, privileged market access and superior financial product knowledge rather than an information advantage. Price distortions arise from inefficient flows and prevail as long as a sizable share of market participants is either unwilling or unable to respond to obvious dislocations. Their root causes can be risk management constraints, liquidity concerns, mechanical trading rules and government interventions. Read more.
The research and management of systemic risk is critical for the long-term performance of investment managers. Portfolio value changes during crises are often extreme and adverse to many sensible trading strategies. It is hard to predict crises. Yet it is possible to judge systemic vulnerability once crisis-like dynamics get underway. This may provide opportunities to liquidity early or to “sit out” market turmoil. This requires preparation of crisis strategies, a realistic calibration of tail risk and an active exchange of market risk information across investment managers. Read more.