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Are We In a Permanent Liquidity Trap?

Grrrrrr.  Paul Krugman is stealing my thunder on the interest rate call that wrecked PIMCO and Bill Gross.  Like myself, Krugman was loudly declaring that interest rates had no reason to rise when QE2 ended in 2011.  Rates fell after QE2 ended, fell a lot and Gross never quite regained his footing.  The rest is history.  So Paul Krugman was dead right.  He said we were in a liquidity trap and that people preferred to hold money and that that meant traditional monetary policy wasn’t working.  And since the economy was weaker than expected then it meant that the risk was not rising inflation, but low or falling inflation and that meant rates would remain low despite the end of QE2.

What I was saying at the time was different.  I said QE didn’t have much of an impact on interest rates to begin with because it was a simple asset swap of safe assets for safe assets.  That is, QE is like swapping a savings account (t-bonds) for a checking account (cash) and since this didn’t change the flow of funds in the economy then there was little reason to expect a change in the composition of the stock of assets to make a huge difference because QE wouldn’t be inflationary.  I’ve also said, flatly, that were are not in a Keynesian “liquidity trap” in the sense that Keynes actually thought.  Most importantly, the Central Bank never really controls the broad money supply in any meaningful way so this whole concept of the Fed being able to control the economy through interest rate changes didn’t apply in the sense that many economists seem to think.

All of this meant, all else being equal, that the end of QE2 wouldn’t cause rates to rise because the demand for safe interest bearing assets would remain the same in a low inflation environment which meant that people would simply gobble up more T-bonds as they were issued or they’d remain indifferent as QE2 ended.  In other words, so long as there’s low inflation the preference for safe interest bearing instruments is always there whether we’re in a “liquidity trap” or not.  So, we agree on the basic story and conclusion, but we disagree on the framework being used to come to this conclusion.

Now, Dr. Krugman has defined the liquidity trap as follows:

“Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.”

That’s pretty friggin’ vague.  And it confuses a lot of people because this is not how Keynes thought of a liquidity trap.  Keynes said the liquidity trap was a period in which cash and bonds became perfect substitutes:

“There is the possibility … that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.”

In other words, the Central Bank cannot stimulate the economy by printing money because banks and consumers will hoard the cash, interest rates will be uncontrollable and monetary policy won’t work.  But this isn’t at all what happened during the crisis and it’s certainly not what’s happening now.   The Fed only lost control of interest rates for the briefest of moments during the crisis and the huge demand for certain types of bonds in today’s environment shows very clearly that there’s a strong portfolio preference for interest bearing assets.  Ie, there’s actually very strong demand for bonds and, in the aggregate, people don’t want to hold cash.  Therefore, cash and bonds are not perfect substitutes.  People literally can’t get enough bonds in today’s environments because they want the interest flows from these instruments.  They aren’t just holding cash as if their liquidity preferences are low.

Worse, the view that the “money printing” would not work was perpetuated by people who said the Fed would print all this money and the banks would simply “hold it” as though their preference was to not make loans.  Ie, they wouldn’t lend it out.   In 2008 Dr. Krugman stated this position clearly:

“Here’s one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there’s no incentive to lend out any increase in the monetary base, because the interest rate you get isn’t enough to make it worth bothering.”

Of course, readers here know that this is nonsense.  Banks don’t “lend out” the monetary base.  The multiplier is a myth. Krugman claims he understood this all along, but his comments clearly convey an erroneous understanding of how banking works.  So the liquidity trap view is clearly wrong for the following reasons:

  1. Banks were never “hoarding” the monetary base or refusing to lend reserves out.
  2. The Central Bank never lost control of interest rates.
  3. Bonds are not viewed as perfect substitutes for cash in the current environment.

 Therefore, the Krugman rationale for a “liquidity trap” was never quite right even if some of the predictions were right.  Yeah, the interest rate channel has proven dysfunctional in the current environment, but not because of liquidity preference, liquidity traps or something like that.  More likely, the interest rate channel has always been a pretty weak way to steer the economy and we didn’t realize it until the current crisis.

 The real question now is, how long is this myth of a “liquidity trap” going to continue?  How long can we continue to say we’re in a liquidity trap when this model is obviously based on flawed thinking?  Or better yet, isn’t it now becoming clear that the Fed NEVER really had an omnipotent type control over the “money supply” and the economy to begin with?  In other words, has the interest rate always been a poor way to enact monetary policy?  I’d say that’s pretty accurate.  And either way, it renders the idea of the liquidity trap misguided at best and useless at worst.

NB – I should also add that it’s wrong to say that monetary policy has become ineffective.  Yes, changing interest rates has become ineffective, but that doesn’t mean that monetary policy as a whole has become ineffective.  I’ve pointed out, on several occasions, that the Fed could enact extraordinary measures which would likely have highly beneficial effects.  Policies such as pegging the long bond rate explicitly, buying municipal bonds (thereby financing state government spending) or buying nonfinancial assets in exchange for cash would all have positive economic outcomes in my view.  The fact that the interest rate channel has become ineffective is not a sign that all potential actions by the central bank are ineffective.

Some Thoughts on Static vs Dynamic Projections

We all have to make projections about the future in just about everything that we do.  It’s just a fact of life.  When one invests their money in certain instruments the ability of those instruments to meet your financial goals will depend on a certain degree of projection about the future and the way those instruments will perform.  Some of us look at historical data and project it forward while others take a more forward looking perspective and engage in what could be thought of as guesswork (or, at times, rejecting the idea that past is prologue).  Forecasting the future is part of any honest approach to asset allocation.

What’s interesting about projecting the future is not necessarily whether you’re trying to project the future or not, but how dynamic your model is in achieving this.  This gets very tricky for several reasons.  Someone like Jeremy Siegel, who’s become famous for his “Stocks for the Long Run” perspective, has a very static view of the world.  That is, he basically assumes that economic growth will continue into the future and that means stocks will expand over time and if you have a long enough time horizon then you are best off owning a portfolio of equities (he’s even recommended leveraging that portfolio up if you can stomach it).  This is a perspective that is generally based on fine assumptions (eg, betting on long-term economic growth is a pretty smart bet in general).  But it also doesn’t reflect our financial lives all that realistically because our financial lives are quite dynamic.  Our financial lives are not these static sort of linear experiences.

This reality is why people love Robert Shiller so much.  Shiller’s view is more dynamic.  Shiller basically says that the world is super duper complex, extremely dynamic and that the market’s participants are extremely irrational.  Shiller uses quite a bit of historical data in his work, but he’ll be the first person to tell you that the past is not necessarily prologue.  People relate to this view because they can see how dynamic their lives are.  Shiller’s model based on irrational behavior and dynamism is something that resonates with people because we experience it every day whereas Siegel’s long-term view is something that doesn’t resonate on a daily, monthly or even an annual basis.

So, which type of view is actually more helpful?  It depends quite a bit.  In a general sense, Siegel’s view is right because the world does tend to adhere to the big trends that drive Seigel’s thinking.  But in a more micro sense Shiller is right and the world does go through these periods of turbulence in the near-term that are consistent with a dynamic world view.

Now, is one model necessarily better than the other?  No!  There are parts of the Seigel and Shiller model that are both right.  And there are parts of both models that are wrong.  Finding which one applies to you more appropriately is a process of learning how certain ideas apply to your personal needs.  There’s a lot of dogma in the world about certain views being “right” or “wrong” when the truth usually lies in the middle.



Not All Bonds Are Created Equal

Here’s some really long-term perspective for you – this chart via Deutsche Bank shows the nominal yields for several government bond markets at present.  The trend is generally the same in all of these charts so they don’t actually look all that different, but I’d argue that there’s a big difference in these bonds:



The thing is, the Italian and Spanish bond yields are being suppressed by the ECB’s interventions.  But under the surface lies a gigantic risk in owning these bonds.  While investors are being paid close to nothing for owning these bonds now there is still a substantial amount of solvency risk involved in owning these bonds.  The thing is, because the European Monetary Union is incomplete, each of the nations using the Euro are the equivalents of states in the USA.  So the risk of insolvency is very real.  In other words, they are essentially users of a foreign currency and can be determined insolvent by virtue of not being able to obtain the necessary funding to remain solvent in that currency.

Of course, it would take a political event for that to occur (the EMU has to essentially choose to let one of the countries go bankrupt), but it might not be as far fetched as you think.  Say, for instance, that Italy’s debt to GDP ratio just continues to worsen and Germany slowly realizes that this country can’t reverse course without debt forgiveness or its own currency.  In that case Germany could essentially choose to pull the plug on letting Italy use the Euro and decide that it’s best to part ways as it becomes clear that the currency union just isn’t working as planned and Germany doesn’t want to get involved in a fiscal union that would alleviate the pressures.

Now, this risk doesn’t exist in the USA at the federal level.  The USA doesn’t have foreign denominated debt and there’s no political risk of the Fed not being able to intervene to hold rates low or buy bonds.  But you actually earn less on a Spanish 10 year bond than you do on a US government bond which is priced about the same as an Italian 10 year in nominal terms.  In my opinion, you have to be insane to hold these bonds and view them as being near equivalents.  In my view, peripheral government bonds are significantly more risky than German Bunds or US government bonds.  And that’s largely because there is massive solvency risk due to a very fragile political landscape.  Investors who don’t realize this could be taking on significantly more risk they realize.

Rail Traffic and Jobless Claims Still Point to Expansion

Just a quick update here on some of the near real-time economic indicators I track.  Rail traffic and jobless claims are among the better macro indicators we see with some regularity.  They’re obviously not a perfect reflection of the economy, but when taken in accordance with the broader picture they certainly help provide some clarity

The latest update on rail trends continues to show signs of modest expansion.  The latest 12 week moving average comes in at 5% which is actually a healthier average rate than we’ve seen through most of the recovery.  Granted, this is just one sliver of the economy, but it is certainly a positive sign (via AAR):


Weekly jobless claims continued their downward trend in recent weeks with the 4 week average dipping below 300K.  This is generally consistent with a healing labor market and a clear sign that the US economy continues to move in the right direction.



All in all, this seems to confirm the “muddle through” macro view I’ve maintained for the last few years and these indicators look consistent with the other indicators I track more broadly….

What is the Purpose Of Interest?

Good question here from the forum:

“Can you explain what actually is the reason/purpose of interest in our modern day monetary system?”

Money is endogenous in the modern monetary system.  That means it can be created by any user within the system and can be created from what is really nothing more than an agreement between parties.  The primary form of money in our system is bank deposits and they are created by banks when banks make loans.  Private banks essentially control the primary payment system that we all use and so they create the primary form of money and maintain the system in which it is used.  If you want to participate in the US economy to purchase goods and services then you need a bank account.

Banks make money by charging you a fee to use their system and to use the money they create within this system.  Because the system is privately controlled there is an element of risk management in everything that a bank does.  That is, if a bank doesn’t properly manage its risks it can end up like Washington Mutual or Northern Rock.  Because banks are private profit maximizing entities they have to balance how they generate a profit and how much risk they take in the process of doing this.

The privately controlled element of this system creates competition which makes banks operate more efficiently and makes them accountable for how they operate their businesses.  But since this payment system is so central to the health of the economy the payment system has a unique relationship within the economy.  And as we’ve all discovered over the last 5 years when the payment system doesn’t work properly the whole economy stops working properly.  And so you get this inherent and tricky mix between government intervention in the banking system and the way banks try to operate within their “free market” to compete.  It’s all a bit messy because the banks are profit maximizing and risk taking entities who can, at times, threaten the health of the entire economy through their ability (or inability) to manage their risks in the pursuit of profit.

When a bank lends you money they are essentially allowing you to use their payment system for a fee.  And they will assess this fee based on the duration in which you want to use that money and the risks you pose to using that system.  So, a borrower with bad credit could be rejected from being allowed to use the payment system that banks operate.  Or the banks could just choose to charge that person a very high fee (interest rate) to use the system.  So, in its simplest form interest is just the fee that banks charge users of the payment system.

Of course, there are lots of instruments which convey a similar temporal relationship like stocks or corporate debt.  These instruments convey a similar type of relationship where one party is again creating a financial instrument to obtain money and thereby paying someone a fee to use that money.  So, for instance, a corporate bond is an agreement by a corporation to obtain bank deposits for a certain period of time at a certain interest rate.  In the process of creating this instrument with lower moneyness than the bank deposit they will pay the lender a fee for the specific period.  They are, in essence, convincing the bank deposit user to forgo using their bank deposits in exchange for a fee.  So you can see how this process of financial asset creation can be thought of within the spectrum of moneyness with different entities creating different forms of money within that system….

I hope that helps answer the question.

The Trade that Led to the Demise of PIMCO Total Return

In a great piece over the weekend Josh Brown goes into some detail on the situation with Bill Gross leaving PIMCO.  He asks the important question – what does an owner of the Total Return Fund do now that Gross is gone?   I’m not going to answer that question, but I did think there was an important lesson in Josh’s post.

In 2011 Bill Gross, who had crushed the aggregate bond market by almost 2% per year before fees for 30 years, made one of the most vocal bets on interest rates that we’ve seen since the crisis.  He was very worried about rising rates when QE ended.  He asked “who will buy the bonds” in his March 2011 monthly letter and his bearish stance on T-bonds led him to reduce his allocation to T-bonds to zero.

I was very vocal about this view at the time because I believed Gross was misunderstanding the impact of QE.  In fact, I thought a large portion of the field of finance and economics was misunderstanding the risks of QE, the “money printing”, etc because they weren’t properly understanding its operational reality.  In essence, Gross was saying that interest rates would rise because QE was ending and the decline in rates due to QE would have to reverse.  That is, of course, unless you don’t think QE had much of an impact on rates to begin with.  If that was your belief and you thought that inflation would remain low (as I did) then there was really no rational reason to expect interest rates to surge following the end of QE2.

Of course, Gross ended up being wrong as rates actually fell after QE2 ended.  The Total Return Fund went on to underperform the long bond by a huge margin PTTRXover the next 2 years and the very public call came under harsh scrutiny.  Investors began to ask if Gross had lost his touch.  And the fund flows reversed out of the fund began as quickly as they’d flooded in after 2008.  As the years went by Gross appeared to never recover from the call and last week we learned that Gross was leaving the firm he founded.

The interesting thing is not that Gross was a victim of bond market ignorance – he’s obviously a bond market genius, far more savvy than a chump like myself.  but he was a victim of macro ignorance.  The implementation of QE by the Fed had forced all market participants to take on a whole new set of understandings.  And those who had a sound understanding of macroeconomics were better prepared to deal with the aftermath.

In my new book I outline 8 rules for picking an asset manager (see here).  Rule 8 is ensuring that a fund manager has a sound understanding of the macro world.  Misunderstanding the big picture creates tail risks in a portfolio because it means that fund manager exposes investors to the risk that he/she could dramatically misunderstand important macro events.  And in a world where everything is becoming increasingly macro oriented (whether it’s Fed policy, dependence on global events, etc) you can’t afford to invest with asset allocators who don’t have a sound understanding of the macro environment.

Of course, understanding the world isn’t a guarantee of future performance.  But I am a big believer in the idea that those with a superior understanding of macro dynamics will be better prepared to manage the risks that threaten investment performance.  In other words, by having a superior understanding we can better understand what we know in addition to what we don’t know.  And this ultimately helps you avoid the pitfalls that befell the PIMCO Total Return Fund.

When Exotic Devices Create Exotic Problems

By Ben Carlson, A Wealth of Common Sense

Vanity Fair has a fascinating article in the latest issue on airplane safety and how it affects pilot error. To make planes safer these days, engineers have designed automated systems that basically allow the planes to fly themselves.

Although the designers of the planes have technically made them as safe as they’ve ever been, accidents do still happen every once and a while. But it’s not the planes, but human error that causes the problems.

The issue is that there can be confusion between the pilot and the machine. An unintended consequence of increased safety for the plane is increased complexity for the pilots. This means most pilots rarely have take over the automated system to deal with a crisis situation, making it much more difficult to handle a crisis if and when it occurs.

Industry experts have warned of the side effects that can arise from this increased complexity for a number of years now:

One of the cautionary voices was that of a beloved engineer named Earl Wiener, recently deceased, who taught at the University of Miami. Wiener is known for “Wiener’s Laws,” a short list that he wrote in the 1980s. Among them:

  • Every device creates its own opportunity for human error.
  • Exotic devices create exotic problems.
  • Digital devices tune out small errors while creating opportunities for large errors.
  • Some problems have no solution.
  • It takes an airplane to bring out the worst in a pilot.
  • Whenever you solve a problem, you usually create one. You can only hope that the one you created is less critical than the one you eliminated.

Wiener pointed out that the effect of automation is to reduce the cockpit workload when the workload is low and to increase it when the workload is high. Nadine Sarter, an industrial engineer at the University of Michigan, and one of the pre-eminent researchers in the field, made the same point to me in a different way: “Look, as automation level goes up, the help provided goes up, workload is lowered, and all the expected benefits are achieved. But then if the automation in some way fails, there is a significant price to pay. We need to think about whether there is a level where you get considerable benefits from the automation but if something goes wrong the pilot can still handle it.”

I found a number of financial implications from this story. Although I’m a huge proponent of automating good decisions with your finances, that doesn’t mean everything can be set-it-and-forget-it forever. It can be dangerous when we do see something unexpected like the Flash Crash and investors freak out and completely abandon their plan.

Most of the time it’s not the model or automated investment process that causes the problem, but the fact that we can’t help ourselves from tinkering with them any time things don’t go as planned. Setting up a systematic, rules-based process only works if you follow those rules.

Far too often investors forget this fact and try to make ad hoc changes on the fly, which rarely works out. When quantitative stratgies fail it’s usually not the model that’s the problem, it’s that those running it aren’t able to control their emotions.

Wiener’s Laws could have been written specifically for the financial markets in many ways:

Every device creates its own opportunity for human error. Any financial model is only as good as the person or team using it.

Exotic devices create exotic problems. Complex strategies can create unforeseen complications.

Digital devices tune out small errors while creating opportunities for large errors. Risk comes in many forms and some models can lead to a false sense of security if you’re not aware of the imbedded risks.

Some problems have no solution. You have to choose which form of risk you want to deal with, risk now or risk in the future.

It takes an airplane to bring out the worst in a pilot. Financial markets magnify bad behavior in even some of the most intelligent people.

Whenever you solve a problem, you usually create one. You can only hope that the one you created is less critical than the one you eliminated. There’s no such thing a perfect portfolio or process. Every strategy involves trade-offs.

There are implications that go beyond the financial world as well. As technology continues to advance we’re all going to have to get used to working with machine-based intelligence both on the job and in our personal lives.

It will be interesting to see how these types of man-machine relationships will evolve.

Read the entire Vanity Fair piece for more:
The Human Factor (Vanity Fair)

Now for the best stuff I’ve been reading this week:

  • Turney Duff: “The single best thing I’ve learned since walking away from Wall Street is: I don’t need that much.” (Café)
  • There are 2 ways to build wealth: (1) Earn more or (2) Save more. Cullen Roche explains why (1) is even more important than (2) (Prag Cap)
  • Things I know to be true (Amni Rusli)
  • 30,000 blog posts later, tons of great lessons from Barry Ritholtz (WaPo)
  • It’s easy being a long-term investor in a bull market. The real test is when things go wrong (Reformed Broker)
  • An argument for international stocks (Novel Investor)
  • A 12 step program for controlling your emotions when investing (AAII)
  • 10 things smart investors never say (Daniel Crosby)
  • What’s on Charlie Munger’s book shelf? (Favobooks)
  • Why economic terrorism is good for the consumer (Leigh Drogen)
  • What’s the half-life on your investment ideas and beliefs? (Research Puzzle)

Government Job Cuts are Driving Down the Labor Force Participation Rate

One point that doesn’t get a lot of airtime in current economic discussions is just how much the US government has cut back on its worforce in recent years.  Government employees are still off by 491,000 since the start of 2008.


This is an unprecedented cut in total government employees.  No President in the post-war era has presided over two terms in which government employment declined through his Presidency.  Not Reagan, not Bush, no one.  In general, they were all huge expanders of government employment.

What’s interesting about all of this is the labor force participation rate which is often cited as a sign of structural weakness in the US economy. Which is true to some degree.  But how much of this decline in the participation rate is due to the government job cuts since 2008?

I went back and ran the figures and added in the trend growth in government employment since 1950.  Rather than cutting half a million jobs since 2008 the US government would have added about 2.4 million jobs.  In this scenario the labor force participation is 64% vs today’s actual rate of 62.8%.  Since the rate peaked at 67.3% it’s declined by 4.5 points.  In other words, the government’s job cuts have accounted for 27% of the decline in the labor force participation rate.   And who knows how much all of that lost input and income could have further multiplied growth and employment….


The Great Gold Debate

I went back on Boom/Bust today to discuss the merits of gold in the economy.  Regulars know my position here:

  • Gold is an unproductive asset that shouldn’t be the center of a portfolio.
  • Gold can serve as a hedging or insurance component of a portfolio.
  • Going back to the gold standard isn’t a wise move because it would lead to imbalances similar to what we’re seeing in Europe today with the fixed exchange rate.
  • Gold is “money”, but it’s generally not a very good form of money because its utility as a medium of exchange is not very high.

This was a fun interview which included some gold heavyweights like Rick Rule, Peter Schiff and Marshall Auerback.  Everyone was very courteous and I thought the overall discussion was very fair and balanced.  Peter and Rick made some smart points (though we also disagreed at points) and I obviously agree with Marshall on a number of things.   Erin Ade and Ed Harrison did a great job moderating the discussion and keeping it on point.

I don’t say much in the first 9 minutes, but I was just lurking in the tall grass (or maybe I was just confused/intimidated by the whole 4 person panel thing going on).  I made a couple of key points after that:

  • The value of the dollar declining in terms of gold or CPI is a useless metric.  You have to compare it relative to real wage rates which have vastly outpaced inflation over the last 100 years (see here for more).
  • It doesn’t make a lot of sense to build a portfolio around an unproductive asset class like gold because its value is based more on the belief that it’s valuable as opposed to some inherent utility (see here for more).
  • The 1800’s were a period of great turmoil.  This commonly cited era included a number of financial panics and depressions.  My favorite line of the debate was at minute 24 when Peter says we should just ignore those depressions….
  • The hyperinflationists have been wrong for 10 years running.  How much longer can these predictions garner attention before we all begin to question the foundation upon which they rest?

Watch the full video below:


Some Thoughts on Risk Parity

This is a very good piece by Cliff Asness on his new blog.  If you don’t follow it then add it.  Cliff is one of the smartest dudes around.  Anyhow, his firm AQR runs a strategy called “risk parity”.  I am not positive where this idea originated, but it was made relatively famous by Asness and Ray Dalio who has been running a form of risk parity for decades.  You can read Dalio’s description of the approach here.

I’m oversimplifying here, but the basic approach is to create a risk balanced approach.  So, if you have a 60/40 stock/bond portfolio most people don’t realize that over 80% of the portfolio’s performance is being driven by the 60% portion because stocks are so much more volatile than bonds.  So you’re not really in a 60/40 when you buy a 60/40.  You’re really in something more like a 80/20.  The idea of risk parity seeks to eliminate this imbalance by making the portfolio risk balanced.  This is generally done by overweighting the low volatility assets in the portfolio to make them equal contributors to the portfolio’s overall risk.  So, if you wanted to make a 60/40 more balanced you might buy a 40/60 stock/bond portfolio and leverage it up 1.5X. This gets you to the same standard deviation, but it beats the living daylights out of a 60/40 portfolio on a nominal and risk adjusted basis (over the last 20 years it generates a CAGR of ~11% vs the 8.4% CAGR of the 60/40 with better risk adjusted figures).

So, what’s good and bad about this approach?   First the good:

  • It’s a smart form of strategic diversification.  In other words, this isn’t just some cookie cutter index fund approach that anyone and everyone can implement.  It’s a very sophisticated and value adding methodology.


  • The focus on fixed income is a nice deviation from so much of Modern Portfolio Theory’s obsessive focus on equity returns and the nonsensical idea that “risk = returns”.  This changes the focus of the traditional debate by ensuring that shareholders are taking a more balanced approach rather than naively jumping into what they think is a “balanced index” like the Vanguard Balanced Index (which actually isn’t very “balanced” at all because the majority of the volatility is derived from the 60% equity portion of the portfolio).


  • Historically, risk parity portfolios add diversification to a portfolio in a way that reduces overall volatility and increases nominal and risk adjusted returns.

It’s not all good though (sorry Cliff).  There are some cons to the risk parity story (as there are in any portfolio):

  • The focus on “risk” as volatility leaves the door open for potential misalignment between the way client’s perceive risk and the way a portfolio’s risks are managed.  Shareholders don’t view risk merely as volatility.  This could result in periods of performance which don’t properly protect shareholders from the way they perceive risk.


  • There is some significant forecasting error risk involved in risk parity.  As with any allocation approach there is some degree of forecasting, but in a portfolio that is fixed income heavy the portfolio relies, to a large degree, on the positive risk adjusted returns of the fixed income portion.  This means that a risk parity portfolio, is, to some degree, a bullish forecast on the future of bonds (at least more so than a traditional balanced index).  The underlying model also involves some forecasting of changing risk dynamics.  This is difficult, if not impossible….


  • The portfolios are sophisticated.  The modeling is a little black boxy (is that a word?) because the idea of “risk” can be perceived differently at different points in the market cycle.  How risky are bonds in a world of ZIRP?  Who the eff knows?  Different models will come up with very different answers and so the degree of sophistication in the  black boxy model is a significant driver of future returns.  The investor doesn’t know how this is being done which creates some degree of added risk.


  • The fees on these portfolios are usually high.  We’re not talking about cookie cutter index funds here.  You’re paying for the modelling and strategic diversification that these portfolios add.  Personally, I am not always comfortable with a 1%+ fee structure, but given the degree of strategic diversification these funds add it could be appropriate for slices of a portfolio for certain people.


  • The leverage issue doesn’t scare me as much as it scares some other people, but it can be deadly in the wrong hands.  Leverage is like steroids – in the right hands it can be used in a controlled and intelligent manner.  In the wrong hands it can be very dangerous.  The use of leverage by someone like Asness or Dalio doesn’t scare me.  But you pay for that management expertise.

Now, the average indexer might say that risk parity portfolios are just another form of “active” management or a “better mousetrap”.  Well, I hate to inform you, but all of those Vanguard funds these indexers own are also active deviations from the global cap weighting being paraded as “passive” in order to create brand differentiation.  They’re just different forms of an actively picked index with lower fees.  They’re no less a “mousetrap” than any other index of assets that deviates from global cap weighting.  It’s just that people who buy Vanguard funds don’t often realize they’re in a mousetrap that’s just a lot less expensive than other mousetraps.

On the whole, I think risk parity is a smart approach, but like a lot of Wall Street’s recent innovations it’s probably too expensive to own in any substantial quantity.  That doesn’t mean it’s inappropriate for all asset allocators, but in a world where future returns are likely to be lower than most people expect the fee story becomes a glaring part of the equation.  If I could buy a risk parity portfolio for the same cost as a balanced Vanguard Index then it would be a no-brainer.  But we’re not there yet….

Read some more on Risk Parity approaches:

Why We Need Robots to Win the Technology War

Peter Thiel had a good piece in the FT today on the debate about robots and whether the rise of technology is a good thing or a bad thing.  I tend to fall on the side that says robots are a good thing, but I do acknowledge that the pace of technological acceleration is frightening precisely because humans can’t come up with enough alternative jobs to offset the rapid growth in robot-led job losses.  Still, Thiel makes an altnernatively superb point:

“Spiralling demand for resources of which our world contains a finite supply is the great long-term threat posed by globalisation. That is why we need new technology to relieve it.”

Technology is costing us jobs, but it’s also keeping costs down by reducing our dependence on the finite supply of natural resources.  We not only need the robots to win this war, but we are dependent on them to win this war.  Technology is the path to energy independence and resource independence.

As for the jobs, well, profit maximizing capitalists aren’t likely to solve that problem because they’re the ones leading the robot charge.  Which is great.  They’re not the bad guys in this war.  But we should realize that if they’re not going to fix the job problem then smarter government policy has to play a bigger role.  And that means lower taxes and more government investment.  Unfortunately, we’re still waiting for the capitalists to reach that magical and mythical “equilibrium” point for us.  And it just ain’t happening…

The Influential Indicator Pointing to Easier Fed Policy

Very good insight here from Sober Look – inflation expectations are falling fast again:

“The 5-year real rates in the US have recently turned positive, which some would suggest represents tighter monetary conditions. With real rates on the rise, the Fed will have a great deal of room to “slowroll” the rate hikes. If inflation expectations fall further, we may see a more dovish stance from the FOMC. “

Yes, that means one thing – if you’re betting on tighter Fed policy any time soon then this doesn’t bolster your case.  We’re seeing low inflation around the globe, continued economic weakness and with inflation expectations falling even further it means that global central banks have more breathing room to continue with their accommodative policy.

I continue to see lots of commentators talking about how “tapering is tightening” or how the Fed is likely to tighten in early 2015.  This indicator makes that a very unlikely scenario unless things change quickly and dramatically….


Boom/Bust Appearance: Macro Thoughts

I joined Erin Ade today on Boom/Bust to talk about some macro events.  The video can be found here, but here’s a brief rundown.  Oh, also, I’ll be joining a Boom/Bust roundtable discussion tomorrow to debate the merits of gold – Peter Schiff will be on the panel so that should be fun….

  • I briefly discussed why I wrote my book, Pragmatic Capitalism and how one of my main goals was to bridge the fields of finance and economics to hopefully provide a superior understanding of how both fields are much more closely intertwined than we often think.
  • Why endogenous money is so hard – in part, it’s because money is something that is a construct of the human mind.  That is, the whole financial system is not necessarily tangible or real in the sense that goods and services are.  So the idea that we have created this whole system out of thin air is not only difficult to comprehend because it’s complex, but it is also somewhat hard to believe in because, ultimately, that’s what our system is built on – trust.
  • Why the low inflation environment is a sign that future returns are likely to be much lower than many people expect.
  • Why buybacks are good for the near-term and bad for the long-term.
  • Why investors are going to have to come to grips with the likelihood of lower future returns.


“The Passive/Active Distinction is About Cost”

I really liked this interview with Joel Dickson of Vanguard.  In the interview he cuts to the chase on the active vs passive debate:

“The active/passive distinction is really more about costs than it is about the intelligence or the randomness of active management.  It is about costs”

I keep harping on this point because I think it’s very important to understand the asset allocation process.  The idea of “passive indexing” serves no purpose other than to create a distinction where there really is none.  That is, a buy and hold asset allocator who picks 500 large cap stocks to own is not doing anything all that different from the buy and hold asset allocator who buys the SPY S&P 500 ETF, IF HIS/HER COSTS ARE THE SAME.  But “passive indexers” would like you to believe that the stock picker is doing something distinctly different as if they are necessarily “active” just because they picked stocks.  This distinction is totally meaningless.  These two asset allocators are doing the exact same thing if they can construct their holdings in the same cost efficient manner (which, by the way, is precisely what firms like WealthFront are starting to do by owning the S&P 500 in its entirety).

So, this debate really comes down to costs.  John Bogle’s “Cost Matters Hypothesis” is the key lesson here.  But I think the “passive indexing” community got a bit overzealous in their demonization of “active” managers over the last few decades and didn’t fully realize that they were also picking assets inside the global aggregate.  Indeed, ALL INDEXERS ARE ASSET PICKERS who are just slicing up the global aggregate index in varying ways.  The difference between smart asset allocators and stupid ones is that the smart ones are fully aware of how much fees, frictions, behavior, etc hurt their long-term returns.  Still, none of this should trump the “Allocation Matters Most Hypothesis”.  That is, your active decision on how you allocate your portfolio over the course of your life will, by a wide margin, trump the “Cost Matters Hypothesis”.  So yes, we should be worried about costs, but not at the detriment of understanding the asset allocation process.


2 & 20 is Dead – 1 & 15 is on the Way Out….

The recent uproar over high fees is not a mere fad.  I think it’s here to stay and I think it’s going to get much worse for high fee financial firms who don’t adapt.  The problem is multi-faceted, but there are two huge headwinds coming for the high fee financial firms:

  1. Technological innovations
  2. A world of low returns

The first one is in our face every day.  You not only have enormous tech efficiencies in the way traditional advisors operate and the way markets operate, which reduces costs across the board, but you also have the robo-advisors and more automated services coming online which are driving costs down across the board.   This means that almost anyone can get reasonably good financial advice for 0.5% or lower.  And that figure could be on the high side as the years go by.

Further, we’re entering a world of low returns.  The share of outstanding public stocks has been reduced substantially relative to bonds over the last 30 years as interest rates have declined and it’s become more cost effective for firms to finance themselves via debt issuance.  And at the same time interest rates have been driven to zero by zero interest rate policy and weak economic conditions.  This combination means that the future returns on asset classes are likely to look nothing like they have in the past – particularly for the slice of asset holders who don’t own that reduced slice of the equity pie.  This means returns are likely to be lower which means that asset managers are going to be competing in an environment that is increasingly competitive for a reduced amount of return.  And as more and more investors realize that the high fee managers are cutting further into their returns than they did in the past they are likely to look for lower cost alternatives.

The uproar over 2 & 20 is just getting started.  Next we’ll hear about 1 & 15 and then 1 & 10 and eventually we’ll start hearing about hedge funds whose fee structures resemble traditional mutual funds (many of which are already on their death beds).  But the bottom line is, this isn’t the end of the decline in overall fees.  And that’s a great thing for investors.