Market Resiliency, Capital Formation, and Investing for Our Future
To mark Enterprising Investor’s 10th anniversary, we have compiled retrospectives of our coverage of the most critical themes in finance and investing over the last decade.
The story of the markets over the last 10 years has been one of remarkable change. Whether it’s capital market structure, capital formation, or financial technology, much of finance has been completely transformed since 2011.
Yet economies are still struggling. Ten years ago, they were in the midst of a flailing recovery from the global financial crisis (GFC). Today, after a prolonged bull market, they are working to overcome the heavy toll of the pandemic. As a result, negative interest rates persist, government debt has ballooned, and pension systems, already underfunded and facing demographic headwinds, have fallen further behind, compounding a worldwide retirement crisis. Adding to the unease, inflation, which had laid dormant for a generation, has returned.
For the last decade, Enterprising Investor has contributed to the dialogue around these issues with a focus on strengthening the resiliency of capital markets and providing a forum for investment practitioners to explore how to reform financial market infrastructure, enhance investor protections, and support market integrity and retirement security as well as their clients. Sunlight is the best disinfectant and by exposing potential sources of systemic risk and trends that may undermine investor trust, we hope to ensure a stronger and more resilient financial system for the future.
With that mind, here we consider the developments of the last 10 years, from negative interest rates, to the rise of cryptoassets, to pension reform, with an eye toward the challenges that lay ahead and how investment professionals can best tackle them. We also highlight some of the more farsighted analysis on these topics written over the years by EI contributors.
Negative Interest Rates and Greater Inflation?
Quantitative easing (QE) policies instituted by central banks in the aftermath of the GFC have led to negative yields for nearly a third of sovereign debt markets. Real negative rates have persisted in Europe as they have in Japan for decades. With good reason, investors now wonder whether negative rates will spread to other markets, how long they will last, and how low they will go.
The pandemic response has contributed to this low-rate environment. In mid-March 2020, bond markets seized up and prime money market funds experienced significant outflows. Central banks acted swiftly to support the global economy and the smooth functioning of the markets by injecting a massive dose of stimulus. Once again, prime money market funds had to be bailed out just as they had during the GFC.
“This [money market run] is part of the wider problem of shadow banking, which undermines the resilience of the financial system,” the CFA Institute Systemic Risk Council wrote in a letter to the SEC this spring. “Without fundamental repairs, disorder will happen again, whether in the money-fund industry, or elsewhere. And after each rescue, the underlying incentives among both investors and intermediaries drive the system toward even bigger problems down the road.”
Today, the most pressing questions for investors are how interest rates can be normalized without tanking the economy and causing unintended consequences, what happens if we fail to normalize over the longer term, and whether inflation is transitory or a larger and more sustained problem.
Vineer Bhansali, author of The Incredible Upside-Down Fixed Income Market from the CFA Institute Research Foundation, fears that the next crisis will bring an expansion of negative rates. On the opposite end of the tails of the distribution is inflation. “Market participants generally believe that inflation is not transitory,” Bhansali says, “that the risk is that we end up having more inflation than less, because there’s just too much money in the system and asset prices are already very high and they might eventually trickle down into prices of goods and services as well.”
That point could be fast approaching.
Rise of Private Markets
The massive expansion of private equity and other private markets is inextricably intertwined with low and negative interest rates and an abundance of liquidity and cheap financing. Indeed, SEC commissioner Allison Herren Lee recently observed, “Perhaps the single most significant development in securities markets in the new millennium has been the explosive growth of private markets.”
The sheer size of private markets, with their $900 billion unicorns, means that a greater proportion of the global economy is in the dark and obscured from view. Private investments provide a distinct informational advantage to the companies receiving the capital thanks to a severe lack of disclosure requirements and transparency. Pensions, endowments, and sovereign wealth funds are assumed to be sophisticated enough to evaluate the risks, but greater disclosure would serve the interests of investors and their end beneficiaries alike. Less transparency may lead to capital misallocation and obscure the impact of climate change and other potential systemic risks. Moreover, private companies are staying private longer or not listing at all. Private capital is so abundant and the potential windfalls so enormous, there is often little incentive for an initial public offering (IPO).
“Because of the vast capital available, relaxed legal restrictions and greater opportunities for founders and early investors to cash out,” Herren Lee noted, “companies can remain in private markets nearly indefinitely.”
Special purpose acquisition companies (SPACs) are the latest phenomenon to come out of private markets. Designed as an alternative to traditional IPOs and funded largely by retail investors, these vehicles have also drawn increased attention. The SEC is wisely focused on how SPACs are structured and the potential for conflicts of interest as well as their fees and disclosures. SEC chair Gary Gensler stressed, “There’s real questions about who’s benefiting and investor protection.”
As an underregulated, high-growth segment of the asset management industry, private investments need more oversight and sunshine.
Fintech, Digital Finance, and the New Investor Class
Artificial intelligence (AI) and machine learning are enhancing investment research and improving many aspects of investment decision making. Innovative financial technologies (fintech) and efficient and accessible new investing platforms have become wildly popular among retail investors, especially during the work-from-home phase of the pandemic.
These advances are changing finance for the better. But there are downsides. Conflicts of interest have already crept in. Platforms that offer “zero” trading costs may make it easy to transact, but on the back-end, some are selling order flow for profit. This type of business model can easily erode investor trust.
Algorithms may also be altering investor behavior for the worse. Gamification that encourages excessive trading could lead investors to take on undue risk and deserves greater scrutiny and potentially regulatory action. As the GameStop fiasco unfolded, for example, concerns about herding behaviors in markets and how excessive concentration in certain datasets, providers, and investments could create system-wide risks.
Cryptoassets, Stablecoins, and CBDCs
The rise of cryptocurrencies and cryptoassets has been a similarly incredible story the last 10 years. Indeed, a bitcoin exchange-traded fund (ETF) may be nearing regulatory approval.
Digital assets and their foundation on the blockchain have propelled a broader movement toward decentralized finance (DeFi) that has now reached critical mass. DeFi is disrupting trading, lending, and asset management business models. Stablecoins, a form of private, synthetic currencies, with some claiming (unaudited) 1-to-1 backing with the US dollar, now facilitate crypto trading and lending. Of course, stablecoins are untested in a crisis and regulators are seeking greater transparency into the assets backing these new cyrptocurrencies.
Investor protection, capital formation, and financial stability should be front of mind as central banks race to offer central bank digital currencies (CBDCs) as an alternative to stablecoins. According to the Bank of International Settlements (BIS), 86% of central banks are researching and developing of CBDCs. How receptive is the market to this innovation? That question will be answered in the next two years as the first wave of CBDCs come online.
Pensions and Retirement Security
A key component of market resiliency is how well pensions systems contribute to retirement security. Achieving broad retirement security is among the most challenging social and economic dilemmas of our time. Pensions affect hundreds of millions of people and represent approximately 40% of all assets under management (AUM). Recent economic pressure from the global pandemic, continued pension underfunding, increased life expectancy, and other demographic trends will have short and long-term effects on retirees. Many of the EI articles from the last 10 years explore potential solutions to the pension problem through, among other approaches, better governance, capital allocation, benchmarking, operating efficiencies, and sustainable investing.
The Mercer CFA Institute Global Pension Index 2021 analyzes the strengths and weaknesses of various pensions from across the world, ranking 43 pension systems based on adequacy, sustainability, and integrity. “With ageing populations, low or negative interest rates for longer, and uncertain investment returns in the future, the financial wellbeing of our future retirees cannot be left to chance,” the authors conclude. “It must be considered now, leading to our recommendations for urgent long-term pension reform in these challenging times.”
Below is a curated selection of some of EI‘s more important pieces on these issues.
Negative Interest Rates
In this 2012 piece, André F. Perold writes that US real interest rates are currently negative, which means that fixed-income investments — which have historically earned almost 3% a year over inflation — now subtract from returns. In this environment, performance pressures are not a reason to abandon sound investment principles. The tenets of preserving capital, maintaining diversification, using active management only when in possession of an edge, and adopting a stable risk policy all help maximize returns while remaining within a given risk tolerance. Institutions could do a lot worse than to heed these principles within their resource and governance limitations.
In today’s financial markets, we live in constant fear of the low interest rate bubble bursting, Joachim Klement, CFA, observes. Wary of extremely low or even negative interest rates, many analysts and economists expect a massive devaluation of assets once interest rates normalize. But more than 10 years after the financial crisis, interest rates have yet to normalize in the United States or Europe. And in Japan, 30 years after the bubble burst, interest rates haven’t normalized either. How long do low or negative interest rates have to hang around before they become real? What if this isn’t a bubble or historic aberration but a permanent state of reality?
In an interview with Lauren Foster, Vineer Bhansali, author of The Incredible Upside-Down Fixed-Income Market from the CFA Institute Research Foundation discussed the underlying implications of negative-yielding bonds and whether they constituted a net negative or positive. They also talked about what would cause rates to go even lower and how inflation influences the rates picture ahead.
Rob Arnott, Joyce Chang, and Louis-Vincent Gave offered their perspectives on the policy landscape and its implications for investment strategy at the premiere Alpha Summit from CFA Institute. Rhodri Preece, CFA, considers their insights.
The US Federal Reserve could be setting the US economy up for a harder fall down the road by flooding markets with cash and spurring investors to prop up firms that are not fit to survive, Danielle DiMartino Booth writes. The long-term risk posed to the economy is that the restructurings that were once emblematic of the creative destruction that fomented innovative new firms will make way for a generation of painful liquidations.
After the global financial crisis, private equity (PE) investors were rudely reminded that illiquidity can magnify downside risks, Mark Harrison, CFA, writes. Abundant capital and cheap finance mean deals are now richly priced in both the United States and Europe as pension funds recover their taste for PE. Yet the the Towers Watson/Financial Times Global Alternatives Survey 2015 notes the continued evolution of the manager-investor relationship and lingering pressure on fees as the asset class matures. Increased co-investing, secondary activity, and strategic partnerships are also increasingly common innovations among sophisticated asset owners.
As ever more capital is allocated to private equity (PE), pundits and practitioners attribute PE’s success to extraordinary performance. That premise is difficult to corroborate. The four-part Myths of Private Equity Performance series by Sebastien Canderle sets out to debunk the most prevalent myths surrounding PE.
Before SPACs, blank-check and shell companies operated under various incarnations throughout financial history, Sebastien Canderle observes. They usually remain niche products with little general appeal, except in the late stages of the economic cycle — not so in 2020 as they drove the IPO boom. The ongoing market dislocation has encouraged yield-seeking investors to take risks and fee-hungry dealmakers to get creative. Investors should be wary of the features of SPACs, including their lack of track records and audited financials, conflicts of interest, and high fees.
The future of artificial intelligence (AI), social media, and finance — of the technology-driven world — should be a promising one, full of automated conveniences and greater freedom, Sameer S. Somal, CFA, and Pablo A. Ruz Salmones maintain. But to realize this outcome, our technological future must prioritize people. And real people don’t fit conveniently into the boxes of an algorithm. It all begins with someone’s voice. As GameStop demonstrated, when that voice gathers support and is amplified by two of the most powerful tools the world has ever seen — AI and social media — it is a recipe for change.
Digital assets have reached critical mass and there’s more to the crypto story than just bitcoin, the authors report. Crypto discussions often ignore the increasing adoption of blockchain technology. Blockchain not only makes crypto possible, but also enables the broader movement towards decentralized finance (DeFi), the secular force that we think is driving the advent of digital currencies. If crypto is to be taken seriously as an asset class and not just a means to speculate on digital art or sports videos, we believe investors should focus on opportunities within DeFi alongside bitcoin.
The future of assets is tokenized. That’s what Avantgarde Finance founder and CEO Mona El Isa told the Alpha Summit by CFA Institute, Julie Hammond, CFA, writes. “If you make that assumption, you can totally re-imagine the infrastructure that finance is built on,” El Isa continued. “You can see a totally automated operational and administrative infrastructure that doesn’t have the same barriers to entry as traditional finance.” El Isa and another blockchain pioneer, Ethereum founder and chief scientist Vitalik Buterin, discuss the evolution of blockchain technology and the future of decentralized finance (DeFi) that is driving change in asset management with moderator Eelco Fiole, CFA.
Accurate performance readings of public pension funds, endowments, and other institutional investors are critical to their trustees and stakeholders. Fund performance is usually evaluated by comparing the portfolio rate of return to that of an index-like benchmark. Richard M. Ennis, CFA, reviews the benchmarking practices of US public pension funds and finds them wanting.
What impact does cost have on public pension fund performance? Quite a dramatic one, it turns out. Richard M. Ennis, CFA, looked at the diversification, performance, and cost of operating large public pension funds in a recent Journal of Portfolio Management article. He finds that large public pension funds underperformed passive investment by 1.0% per year in the decade ended 30 June 2018. The margin of underperformance closely approximates the independently derived cost of investment. He concludes that public pension funds are high-cost closet indexers and that the vast majority will inevitably underperform in the years ahead.
Pension funds need to reduce costs. They can accomplish this, in part, by fully embracing passive management and low-cost alternatives, Nicolas Rabener contends. But that won’t be enough to meet their goals. Governments will have to increase the retirement age, and by a significant margin, to reduce liabilities. But given the poor return outlook, that likely won’t be sufficient either. And that means pension benefits have to be cut. With inequality already tearing at the fabric of society, reducing benefits to the elderly has the potential to rip it apart.
Antonio Rodriguez, CFA, CIPM, the director of investment strategy for the New York City Board of Education Retirement System (BERS) explains that the pension retirement system was not designed for its current size and complexity in an interview with Paul Kovarsky, CFA. “Nobody foresaw the level of assets under management, and what that would require in the form of governance,” Rodriguez says. “Public pension plans today have liabilities to pay pensions to their current members that will live into the 22nd century. This means that their trustees are overseeing investment not just for the long term, but rather for a very long term. Perpetual investing is the way some may label what is really involved.”
The sustainability of traditional public sector defined benefit (DB) plans has become front-page news and the subject of acrimonious debates usually framed in stark terms of DB versus DC (defined contribution). This either / or framing is unhelpful, Keith Ambachtsheer writes. It simply perpetuates the strongly held views of the defenders and critics of these two opposing pension models. Moving the pension reform yardsticks in the right direction requires that we stop this dysfunctional either / or framing and embrace a more constructive conversation about what we want our pension arrangements to achieve and what that tells us about how to design them.
What is the highly acclaimed Canadian public pension fund model, and can its methods be translated to other countries? To address these questions, a panel from the Ontario Teachers’ Pension Plan, Caisse de dépôt et placement du Québec and other experts discussed the key characteristics of the Canadian model, Mark Harrison, CFA, explains. The group agreed that what distinguishes the Canadian model is its clarity of purpose, governance structure, and independent decision making.
“Where are the screaming actuaries yelling in these burning theaters?” Jeremy Gold once asked. Gold passed away in 2018, leading Heidi Raubenheimer, PhD, CFA, to recall his words and reflect on the state of the retirement crisis.
When clients ask you whether the hodgepodge of social security programs, private savings accounts, and employer-sponsored retirement plans that we collectively rely on will be sufficient to provide them with a comfortable living after they stop working, you probably have an easy answer at the ready. “Ha!” Sloane Ortel considers what’s required for a truly functional retirement system.
Stuart H. Leckie and Rita Xiao, CFA, review the reforms to China’s pension system and assess the challenges that lie ahead. They conclude that in order to effectively carry out all pension reforms with world-class coordination at all levels, a China Pensions Regulatory Commission should be established as a new regulator specifically for the pension sector, and should take over full responsibility and oversight for pension design and financing in China.
A higher return on plan assets reduces the funding requirements for the pension plan and the expense that the sponsor must report, Lawrence N. Bader says. But the plan’s true economic cost is independent of the investment performance of the plan assets.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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