Distress Testing The Efficient Frontier by Danielle DiMartino Booth, Money Strong

Many historically inclined residents of White Plains, New York can recount the legend of Sleepy Hollow and what inspired it. The day was October 31, 1776 and our young Revolution was in the throes of a heated battle. One this bloody All Hallows Eve, so stirred by his witnessing of a horrific incident on the Merrit Hill battlefield was American General William Heath that he dramatically recorded the horror of it in his journal as such: “A shot from the American cannon at this place took off the head of a Hessian artillery-man. They also left one of the artillery horses dead on the field. What other loss they sustained was not known.”

Efficient Frontier

Distress Testing The Efficient Frontier

It was the general’s vivid recollection of this scene that was to be the inspiration for author Washington Irving’s penning of his classic ghostly retelling of Heath’s journal entry, America’s version of a common folk tale dating back to Celtic times when for the first time the Headless Horseman set out on his eerie ride.

Today, investors may find themselves wondering just what financial spirits have already been unleashed to darken the legacy of the Federal Reserve’s current head. They know what lingers to ominously shadow two of her notable predecessors. Alan Greenspan will forever be disturbed by the ghost of irrational exuberance, and his successor Ben Bernanke by the vestiges of subprime being “contained.” Given the state of the financial markets today, odds are Janet Yellen will be perennially preoccupied by the death of the efficient frontier.

In a perfect world, as we were schooled in Portfolio Management 101, investors maximize their return while minimizing their risk. To accomplish this, we’ve long relied on the work of Harry Markowitz who, in 1952, developed a system to identify the most efficient portfolio allocation. Using the expected returns and risks of individual asset classes, and the covariance of each class with its portfolio brethren, a frontier of possibilities is conceived. Where to settle on this frontier is wholly contingent on a given investor’s unique risk appetite. And so it went – in yesteryear’s perfect world.

Unfortunately, the Fed’s fabricating of a different kind of perfect world has all but rendered impotent the efficacy of the efficient frontier. There are countless ways to illustrate this regrettable development, one of which can be viewed through the prism of volatility.

Investors are now so enamored of the good old days, when assets traded in volatile fashion based on their individual risk characteristics that the “VIX” has become a household name. In actuality, it is as it appears in its all-cap glory – a ticker symbol for the Chicago Board of Options Exchange Volatility Index. What the VIX reflects is the market’s forecast for how bumpy things might, or might not, get over the next 30 days.

As is stands, at about 13, the VIX is sitting on its 2016 lows which are on par with where it was in August following the Chinese devaluation scare. But it has not been uncommon in market history for the VIX to dip below 10 into the single digits, as it did in late 1993. It again broke below 10, but with much more fanfare, in 2007 ahead of a vicious bear market that ravaged investors in all asset classes.

Writing up to 16 markets briefs per year for nearly a decade inside the Fed required no small amount of title-writing technique. One of the most memorable of these immortalized in early 2013 was “Fifty Shades of Glaze,” which touched on the very subject of investor complacency using the VIX as evidence. The Wall Street Journal reported on March 11 of that year that investors were “worry free” in light of the VIX falling below 12, a number not seen since 2007.

The hissy fit that markets pitched a few months later following the Fed’s threats to taper open market purchases served to send the VIX upwards. But things have since settled down, convinced as markets are that lower for longer is the newest ‘new normal.’ In a seemingly comatose state, the VIX has breached 15 on the downside twice as often since 2013 as it has on average since 2005.

“I’ve been making the argument since 2010 that heavy-handed central bank policy is destroying traditional relationships,” said Arbor Research President Jim Bianco, who went on to add “stock picking is a dead art form.”

By all accounts, Bianco’s assertion is spot on – the death of stock picking has not been exaggerated. It’s no secret that indexing is all the rage; index-tracking funds now account for a third of all stock and bond mutual fund and exchange-trades fund assets under management.

The problem is that the most popular index funds have distorted valuations precisely because passive investing has become so popular. Consider the biggest index on the block, the S&P 500. Now break it down into its 500 corporate components. Some are presumably winners and some not so much. But every time an investor plows more money into an S&P 500 index fund, winners and losers are purchased as if their merits are interchangeable. The proverbial rising tide lifts all boats – yachts and dinghies alike.

If that sounds like a risky proposition, that’s because it is. Not only are stocks at their most overvalued levels of the current cycle, index funds are even more overvalued, and increasingly so, the farther the rally runs.

As Bianco explained, “In today’s highly correlated world, company specifics take a back seat to macro considerations. All that matters is risk-on and/or risk-off. Unfortunately, this makes the capital allocation process inefficient.”

The question is, what’s a rational, and dare say, prudent investor to do? In one word – suffer.

Pension funds continue to fall all over one another as they jettison their hedge fund exposure; that of New York City was the latest. It’s not that hedge fund performance has been acceptable; quite the opposite. But ponder for a moment the notion that pensions no longer need to hedge their portfolios. Is the world truly foolproof?

Of course, hedge funds are not alone in being herded to the Gulag as they are handed down their Siberian sentences. All manner of active managers have underperformed their benchmarks and suffered backlashing outflows. They’ve just come through their worst quarterly performance in the nearly 20 years records have been tracked.

And so the exodus from active managers continues while investors maintain their dysfunctional love affairs with passive, albeit, aggressive investing.

When will this all end? It’s hard to say. Bianco contends that it’s not as simple as what central banks are doing – they’ve abetted economic stimulus efforts before. Remember the New Deal? What’s new today is the size and scope of the intervention.

How will it end? We actually have an idea. Passive bond funds “enabled the borrowing binge by U.S. oil and gas companies,” as reported by Bloomberg’s Lisa Abramowitz. It was something of a vicious process that started with – surprise, surprise – zero interest rates compelling investors to reach for yield.

Enter risky oil and gas companies whose bonds sported multiples of, well, zero. It all started out innocently enough in 2008, with these issuers having some $70 billion in outstanding bonds. But every time they floated a new issue to hungry managers, their weight in the index grew proportionately. In the end, outstanding bonds for this cohort rose to $234 billion.

“Their debt became a bigger proportion of benchmark indexes that passive strategies used as road maps for what to buy,” Abramowitz wrote. “Leverage begot leverage begot leverage.”

Since June 2014, some $65 billion of this junk-rated debt has been vaporized into a default vacuum. Yes, passive investing involves lower fees. But it can also suffer as indiscriminate buying can just as swiftly become equally indiscriminate selling. Such is the effective blind trust index investors have put in central bankers to never allow the rally to die.

“The actions of people like Janet Yellen or Mario Draghi matter far more than any specific fundamental of a company,” Bianco warned. “It’s as if every S&P 500 company has the same Chairman of the Board that only knows one strategy, resulting in a high degree of correlation between seemingly unrelated companies.”

Nodding to this dilemma, several years ago, the CFA Society raised a white flag on the efficient frontier in a Financial Times article. Any and all applicants were welcome to suggest a new order, a new way for investors to safely design portfolios to comply with their individual risk tolerance.

Just think of the inherent quandary facing the poor folks who run insurance companies. These firms have a fiduciary duty to own at least some risk free assets. That’s kind of hard to do when yields on these assets are scraping the zero bound, or worse, are negative as is the case with some $7 trillion in bonds around the globe.

“Investors have traditionally been able to build balanced portfolios with the inputs of risky and risk-free assets,” said one veteran pension and endowment advisor. “Now that risk-free assets sport negative yields in many countries, to earn any return at all, you have to take undue risk. This breaks the back of the whole equation that feeds the efficient frontier.”

A while back, Yellen warned investors of the potential pitfalls of owning high yield bonds. She was no doubt studying data that showed mom & pop ownership of these high octane assets was at a record high. Many onlookers balked at the head of a central bank wading into the wide world of investment advice.

But perhaps it’s simply a case of recognizing one’s legacy well in advance. Small investors today have record exposure to passive investing. If Yellen fully grasps what’s to come, she’s no doubt preemptively struck and tormented by the future ghost of rabid animal spirits.

“It’s like giving a teenage daughter a Ferrari and hoping she won’t speed,” the advisor added. “If central banks keep price discovery in shackles indefinitely, Markowitz will have to return his Nobel prize.”

Let’s hope not. If that’s the case, and the efficient frontier never regains its rightful place in the investing arena, we will find ourselves looking back with less than wonderment as the hedgeless horseman gallops away with our hard earned savings.