A major challenge faced by all investors is framing any particular market moment in the right context. Our investment lives are relatively brief: looking at the industry, it is remarkable how few people can easily remember the pre-Financial Crisis market dynamics. This phenomenon becomes more striking the further back one goes. Almost nobody working in the industry today has any real understanding of what markets were like in the 1970s – when Paul Volcker was at the Federal Reserve (Fed) and high interest rates were the norm.
Consequently, when considering the active versus passive debate, it is important to bring a longer-term perspective to bear. From the mid-1980s to early 2015, average annual returns for developed world equities were around 8%, while bond markets returned around 5%. This is approximately double the historic average for the prior 100 years. What were the reasons for this? And what should be considered normal – the recent past or the period before that?
It is my view that we have been in an aberrational super cycle since the early 1980s. Before this time, the US was essentially a nation of savers. Then Ronald Reagan became president in 1981, and with the new Fed Chairman Alan Greenspan, set about putting the country on a path to debt-fuelled growth. The fiscal and monetary policies of this time turned the US into a nation of borrowers, with interest rates coming down significantly. It was ‘Morning in America,’ as the political campaign slogan went, and the future was going to be brighter – so why not borrow and spend? In turn, countries like China benefitted by making goods that were in demand, and funnelled a lot of this newfound wealth into US Treasuries, with this demand keeping interest rates low in the US. Much of the developed world followed suit and the amount of leverage introduced into the basic economic cycle increased in a fundamental way.
Certainly, it has not all been smooth sailing since then. 1987, 1994, 1998 and 2001 were all periods where markets experienced a downturn – caused by a variety of reasons including poor communication from the Fed, emerging market issues, technology bubbles, and so forth – but essentially it was one long super cycle.
When the Financial Crisis hit in 2008/09, the prevailing wisdom among economists and market participants was that this would mark the end of the super cycle – perhaps with the outcome of a depression akin to that of the 1930s. But the lessons of the depression were well learned by Ben Bernanke and his colleagues, and indeed no policymaker wants to watch the economy implode on his or her watch, so they did everything they could to avoid this happening. In hindsight, we recognise that they effectively threw the entire toolkit of monetary policy at the challenge, which resulted in interest rates going down to zero or even turning negative: at one point there was over USD10 trillion of bonds with negative yields, some with duration as long as 10 years.
As with any powerful drug, this quantitative easing strategy had a series of unintended consequences. With fixed income yields at historic lows, investors piled into equities and risk assets. The value of these assets rose almost indiscriminately and created a one directional market that lasted from late 2009 to the start of this year.
However, perhaps the most notable of the aforementioned consequences was that income inequality widened significantly over this period. It is not without irony that central bank action to avoid a depression ended up creating a major point of tension in the fabric of society: those with risk assets (the wealthy) saw their holdings appreciate significantly at the same time as the median wage stagnated; companies have not had to raise wages due to widespread job insecurity. In fact it is only now that we are starting to see any wage growth for the median worker, despite the fact that several developed countries have been close to, or even beyond, full employment for a while.
Another big side effect has been the significant growth of passive investments. To use an analogy, imagine there are two boats in the ocean: one has a trained crew of rowers and the other is empty. Naturally, the one with the crew costs more to operate than the empty one. Now imagine Poseidon, the Greek god of the sea, casts a spell so that ocean currents flow in only one direction, every day, for years. At the end of each year, the empty boat will have travelled at least as far, if not farther, than the boat with a crew -- humans tend to make decisions and would likely row a little this way and that, and this boat would certainly weigh more than the empty one, slowing it down. Importantly, the empty boat will have probably gone further and faster at a far lower cost than the one with humans.
While this clearly simplifies the situation, it does highlight the single-direction market, driven by central bank policy, underpinning the migration towards passive investments. However, as the song goes, ‘times, they are a changing.’ The coordinated and unprecedented central bank policy in place since 2009 is starting to be unwound and markets, in turn, are beginning to experience a re-emergence of volatility. For active managers, this should be an encouraging sign that suggests the era of smooth, pilot-less investing is likely to lead to less attractive outcomes, and that ‘steering’ should matter once more.