Earlier this year, Oaktree Capital Management’s Howard Marks asked what is perhaps the most important question for capital markets: “What would happen if a large number of holders decided to sell a high yield bond ETF all at once?”
The answer, of course, is that fund managers would be left with a massive, non-diversifiable, unidirectional flow which would force them to either tap emergency liquidity lines with banks to meet redemptions or else risk selling the underlying bonds into an increasingly thin secondary market for corporate credit; the former option is a delay-and-pray scheme while the latter has the potential to trigger a sum-of-all-fears scenario wherein illiquidity quickly begets a fire sale.
“The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid,” Marks warned.
Recently, the “lonely contrarian” spoke to Goldman on topics ranging from manipulated markets to investor psychology. Here are some notable excerpts.
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From Goldman’s “Fortnightly Thoughts”
How can we understand investor psychology and use it to make investment decisions?
It’s the swings of psychology that get people into the biggest trouble, especially since investors’ emotions invariably swing in the wrong direction at the wrong time. When things are going well people become greedy and enthusiastic, and when times are troubled, people become fearful and reticent. That’s just the wrong thing to do. It’s important to control fear and greed.
Why do behaviour patterns and mistakes recur despite the plethora of information available now? Are we doomed to repeat our mistakes?
The bottom line is that even though knowing financial history is important, requiring people to study it won’t make a big difference, because they’ll ignore its lessons. There’s a very strong tendency for people to believe in things which, if true, would make them rich. Demosthenes said, “For that a man wishes, he generally believes to be true” Just like in the movies, where they show a person in a dilemma to have an angel on one side and a devil on the other, in the case of investing, investors have prudence and memory on one shoulder and greed on the other. Most of the time greed wins.
Is it volatility that’s made people scared of equity markets, particularly since 2000?
Volatility goes in both directions but it’s declines that people dislike, not volatility. In 2000, people pursued growth but forgot to ask themselves ‘at what price?’ And in recent years they’ve been pursuing safety and income while ignoring the same question. Today the price being paid for the safety and income of bonds is among the highest in history.
How do you think about the current very low interest rate regime?
Yes. The point is that today you can’t make a decent return safely. Six or seven years back, you could buy three to five-year Treasurys and get a return of 6% or so. So you could have both safety and income. But today, investors have to make a difficult choice: safety or income. If investors want complete safety, they can’t get much income, and if they aim for high income, they can’t completely avoid risk. It’s much more challenging today with rates being suppressed by governments. This is one of the negative consequences of centrally administered economic decisions. People talk about the wisdom of the free market – of the invisible hand – but there’s no free market in money today. Interest rates are not natural. They are where they are because the governments have set them at that level. Free markets optimise the allocation of resources in the long run, and administered markets distort the allocation of resources. This is not a good thing… although it was absolutely necessary four years ago in order to avoid a complete crash and restart the capital markets.
Looking at the current scenario, is your level of caution and concern as high as it was during 2006-07?
The worst things that occurred in 2006-07 are not happening as much today. But currently I’m just cautious, like I was in 2004-05. And some people might easily argue that I turned cautious too early.
If it’s human nature that causes the bubbles and crashes, do you think asset management should be done with more machines and fewer people?
No, I disagree strenuously. People who doubt the existence of inefficient markets and the ability to profit from them may disagree with me. But if you think you’re operating in an inefficient market like I try to do, a lot can be accomplished by getting great people, developing an effective investment approach, hunting for misvaluations, keeping psychology under control, and understanding where you are in the cycle. I am not saying that everyone should try this. In fact, an algorithm or an index fund may work best for a lot of people. But at Oaktree, we don’t make heavy use of machines. We are fundamentalists and ours is a “non-quant shop.” As long as there are people on the other side making mistakes – failing to fully understand assets, acting emotionally, selling too low and buying too high – we’ll continue to find opportunities to produce superior risk-adjusted returns. This is something I’m very sure of.