In the 1840’s, Ireland imported infected fertilizer from Peru produced cheaply by indigenous slaves. Potato monocropping meant that the crop was not resilient enough to the infection, and half of the country’s production was wiped out in under four years. Famine and mass emigration ensued — one of the largest movements of people in history to that time. Today, markets have imported a contagion of their own.
Today’s infected fertilizer is the State-driven Liquidity Impulse.
Produced cheaply and leveraged to involuntary future tax collections, these liquidity impulses have corralled investors into a monoculture of strategies, positions, and risk management ideologies.
Passive strategies or ones which generate returns from falling volatility are a hair’s breadth away from global failure. Modern Portfolio Theory has led to competition on fees for correlated, commoditized products driven by bets on continued sameness rather than difference. Cycles of bureaucratization create falling differentiation among managers all vying for crumbs of return. Philosophies of true outperformance have gone out the window.
It’s a race to the middle.
As the private fund business approached $3.5T in assets, with 1,500+ managers, it’s no wonder strategies started under-performing. Managers have come to compete with one another to become a more superior representation of the absolute average of all managers in a winner-take-all, zero profit tournament. Idiosyncratic views cannot be tolerated because the entry price is to divest oneself of the possibility of regime change.
The industry is dominated by regression-to-the-mean thinking.
Investors see risk management as rerunning the past through a computer, as opposed to exercises in game theoretic deduction based on axioms, for example. Risk measurements based on analysis of a history of mean-reversion break down as we travel into the teeth of one of the largest economic shifts of the last hundred years. Markets are more leveraged than at any time in history, and thus the worse the consequences of being wrong.
Investors do not have the luxury to lean on ten years of statistics before they adjust their worldviews.
The last ten years have been some of the best in financial market history. Baby Boomers are not wrong to see them as a redemption for the headaches of the three major equity market routs of their careers. But squeezing the rock for a few more ounces of return is penny-wise-pound-foolish and not a substitute for serious thinking about the future. We must recognize a new regime of volatility is on the horizon.
This new regime must be populated with a polyculture of divergent thinkers. Investment minds and habits planted close together, but with very different DNA. There is an elegant sophistication which lives outside the world of the monolithic central bank put. Smaller in scale potentially, but richer and more cultivated. Our social durability and our returns depend on it.
-RC
