There’s no doubt that the Fed’s impositions of its zero-interest-rate policy (ZIRP) and numerous bouts of quantitative easing (QE) since the 2008 credit crisis have worked to the detriment of active investors and traders alike. Why? Because the Fed doesn’t care about your picking one stock over another. All the Fed and its central bank brethren care about is pushing you out on the asset allocation risk curve, which for the vast majority of market participants just means long equity exposure. Any stock. All stocks. This is why the quality bias that most investors have — preferring solid management, strong balance sheets and good cash flow generation to their opposites — has been largely immaterial as an investment factor (if not an outright drag on returns) during the past six years. If the King is flooding the town with easy credit, the deadbeat tailor will do relatively better than the thrifty mason every time. It’s just as bad for traders who couldn’t care less about fundamentals but are beholden to this correlation pattern as the extraordinary policies of central banks around the world swamp historical correlations.
So active portfolio managers of all stripes and strategies are looking forward to Fed policy “normalization,” where short-term interest rates are slowly moved up off the zero bound and the bloated Fed balance sheet slowly runs off. The hope is that without the heavy hand of the Fed pressing markets and the real economy away from the deflationary equilibrium, then perhaps there will be more room for active trading strategies to work. The positive impact of Fed normalization won’t happen in a flash, of course, and it will be felt most keenly in market sectors that are more closely connected to secular growth. But ultimately all active managers will enjoy the fresh air of monetary policy normalization. That’s the hope, anyway, and it’s real, provided that the Fed actually gets on with it.
We need to recognize, however, that we’ve experienced a second structural shift in markets coincident with ZIRP and QE that has been equally damaging to active management; particularly active derivatives strategies like volatility and correlation, and unlike monetary policy, this structural shift can’t be reversed. The mega-allocators are adopting these strategies at a frighteningly rapid clip, pushing billions into “portfolio overlays,” “risk premia” and the like. That may be a good thing in the sense of providing a full-employment act for traders, but it’s a very difficult thing for active managers who have carved out a niche in derivatives.
Why? Because just as we saw in commodity markets from 1970 to 2000, the entrance of new, deep-pocketed players with different preference functions than the prior players both depresses average strategy returns and pushes poorly capitalized players to take greater and greater risks just to stay even. It’s a phenomenon that’s as old as futures themselves, and if you use the words “contango” and “backwardation” on a daily basis you know what I’m talking about. Giant institutions like pension funds, sovereign wealth funds or trillion-dollar asset managers attach a very different meaning to derivative strategies than prop desks or even multi-strategy hedge funds. They’re not playing this game with an eye towards edge and odds, seeking to maximize a return growth rate over time in some Kelly Criterion fashion.
No, they’re trying to achieve an overall portfolio target rate of return while hewing to a targeted volatility path, where the derivative strategies are seen as a non-correlated complement rather than as a standalone effort. Because the big boys are playing a larger game, the prior inhabitants of each individual volatility or correlation ecosystem are increasingly faced with totally different, head-scratching and P&L-killing price action than anything they’ve experienced. And there’s nothing that Fed normalization will do to stop it.
You can wait out cyclical impediments to your business model like monetary policy, and with any luck active managers will see more room to act as the Fed normalizes. But for structural market shifts like the mainstream adoption of derivative trading strategies, waiting for things to get better is foolish. Is all lost for active volatility and correlation traders in this brave new world of mega-allocator derivative activity? Of course not. It won’t be as much fun as it used to be, when the rest of the world was blithely unaware that gamma is a thing, and it will be more necessary than ever for active managers to achieve scale. But adaptation to structural change is never fun. Just necessary.
W. Ben Hunt, Ph.D, is chief risk officer of Salient Partners ($22 billion in assets), and the author of Epsilon Theory market commentary. @epsilontheory